Measuring
the Cost of Living
u Inflation
refers to a situation in which the economy’s overall price level is rising.
u The
inflation rate is the percentage change in the price level from the previous
period.
The
Consumer Price Index
u The consumer
price index (CPI) is a measure of the overall cost of the goods and
services bought by a typical consumer.
u When the
CPI rises, the typical family has to spend more dollars to maintain the same
standard of living.
How
the Consumer Price Index Is Calculated
u Fix the
Basket: Determine what prices
are most important to the typical consumer.
u Find the
Prices: Find the prices of each of the goods and services in the basket for
each point in time.
u Compute
the Basket’s Cost: Use the data on
prices to calculate the cost of the basket of goods and services at different
times.
u Choose a
Base Year and Compute the Index:
u Designate
one year as the base year, making it the benchmark against which other years
are compared.
u Compute
the index by dividing the price of the basket in one year by the price in the
base year and multiplying by 100.
u Compute
the inflation rate: The inflation rate
is the percentage change in the price index from the preceding period.
The
Inflation Rate
The
inflation rate is calculated as follows:
Calculating
the Consumer Price Index and the Inflation Rate: An Example
See Example
In Class
Calculating
the Consumer Price Index and the Inflation Rate: Another Example
u Base Year
is 1998.
u Basket of
goods in 1998 costs $1,200.
u The same
basket in 2000 costs $1,236.
u CPI =
($1,236/$1,200) X 100 = 103.
u Prices
increased 3 percent between 1998 and 2000.
Problems
in Measuring The Cost of Living
The CPI is an accurate measure of
the selected goods that make up the typical bundle, but it is not a perfect
measure of the cost of living.
u Substitution
bias
u Introduction
of new goods
u Unmeasured
quality changes
Substitution
Bias
u The basket
does not change to reflect consumer reaction to changes in relative
prices.
u Consumers
substitute toward goods that have become relatively less expensive.
u The index
overstates the increase in cost of living by not considering consumer
substitution.
Introduction
of New Goods
u The basket
does not reflect the change in purchasing power brought on by the introduction
of new products.
u New
products result in greater variety, which in turn makes each dollar more
valuable.
u Consumers
need fewer dollars to maintain any given standard of living.
Unmeasured
Quality Changes
u If the
quality of a good rises from one year to the next, the value of a dollar rises,
even if the price of the good stays the same.
u The BLS
tries to adjust the price for constant
quality, but such differences are hard to measure
Problems
in Measuring the Cost of Living
u The
substitution bias, introduction of new goods, and unmeasured quality changes
cause the CPI to overstate the true cost of living.
u The issue
is important because many government programs use the CPI to adjust for changes in the overall level of
prices.
u The CPI
overstates inflation by about 1 percentage point per year.
Other
Price Indexes
u The
producer price index, which measures the cost of a basket of goods and services
bought by firms rather than consumers.
u The GDP
Deflator, which reflects the costs of all goods and services produced
domestically rather than all goods and services consumed. Also, basket of goods used to calculate GDP
deflator changes automatically as composition of output changes.
GDP
Deflator vs the CPI
u There are
two important differences between the indexes that can cause them to diverge.