N.

GREGORY MANKIW
The Consumer Price Index
PRINCIPLES OF
MACROECONOMICS  Consumer Price Index (CPI)
Eighth Edition – Measure of the overall level of prices
– Measure of the overall cost of goods and
services
– Bought by a typical consumer
CHAPTER Measuring the – Computed and reported every month by
the Bureau of Labor Statistics
Cost of Living
PowerPoint Slides prepared by:
V. Andreea CHIRITESCU
Eastern Illinois University
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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
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Calculating CPI Calculating CPI

1. Fix the basket 4. Chose a base year and compute the CPI
– Which prices are most important to the – Base year = benchmark
typical consumer • Price of basket of goods and services in current
– Different weight year
• Divided by price of basket in base year
2. Find the prices
• Times 100
– At each point in time
5. Compute the inflation rate
3. Compute the basket’s cost CPI in year 2−CPI in year 1
Inflation rate in year 2 = × 100
– Same basket of goods CPI in year 1

– Isolate the effects of price changes

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 3 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 4
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 Table 1. Calculating the Consumer Price Index and Table 1. Calculating the Consumer Price Index and
the Inflation Rate: An Example the Inflation Rate: An Example

This table shows how to calculate the CPI and the inflation rate for a hypothetical economy This table shows how to calculate the CPI and the inflation rate for a hypothetical economy
in which consumers buy only hot dogs and hamburgers. in which consumers buy only hot dogs and hamburgers.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 5 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 6
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The Consumer Price Index The Consumer Price Index

 Inflation Rate  Producer Price Index, PPI
– Percentage change in the price index – Measure of the cost of a basket of goods
• From the preceding period and services bought by firms
 Core CPI – Changes in PPI are often thought to be
– Measure of the overall cost of consumer useful in predicting changes in CPI
goods and services excluding food and
energy

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 7 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 8
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 Figure 1. The Typical Basket of Goods and Services
The Consumer Price Index
 Problems in measuring the cost of living
– Substitution bias
 Prices do not change proportionately
 Consumers substitute toward goods that have
become relatively less expensive
– Introduction of new goods
 More variety of goods
– Unmeasured quality change
This figure shows how the typical consumer divides spending among various categories of
goods and services. The Bureau of Labor Statistics calls each percentage the “relative  Changes in quality
importance” of the category.

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 9 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 10
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GDP Deflator versus CPI GDP Deflator versus CPI

 GDP Deflator  GDP deflator
– Ratio of nominal GDP to real – Compares the price of currently produced
GDP goods and services
– Reflects prices of all goods &  To the price of the same goods and services
services produced in the base year
domestically  CPI
“The price may seem a
 CPI little high, but you have – Compares price of a fixed basket of goods
– Reflects prices of goods &
to remember that’s in
today’s dollars.”
and services
services bought by consumers  To the price of the basket in the base year

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 11 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 12
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 Figure 2. Two Measures of Inflation
Correcting Economic Variables
 Dollar figures from different times
Amount in today′s dollars =
Price level today
= Amount in year T dollars ×
Price level in year T
 A price index such as the CPI
– Measures the price level and thus
determines the size of the inflation
correction
This figure shows the inflation rate—the percentage change in the level of prices—as
measured by the GDP deflator and the CPI using annual data since 1965. Notice that the two
measures of inflation generally move together.
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Regional Differences in the Cost of Living Figure 3. Regional Variation in the Cost of Living

 The cost of living varies

– Not only over time This figure shows how
the cost of living in the
– But also, over geography fifty U.S. states and
the District of
Columbia compares to
 Regional price parities the U.S. average.

– Measure variation in the cost of living

from state to state.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
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 Regional Differences in the Cost of Living
Correcting Economic Variables
 Regional differences explained by
 Indexation
– Prices of goods – small part
– Automatic correction by law or contract
– Prices of services – larger part
– Of a dollar amount
– Housing services – persistently large
– For the effects of inflation
– COLA: Cost-of-living allowance

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Interest Rates in the U.S. economy

Real and Nominal Interest Rates
 Nominal interest rate
 Nominal interest rate
– Always exceeds the real interest rate
– Interest rate as usually reported
– U.S. economy has experienced rising
– Without a correction for the effects of consumer prices in every year
inflation
 Inflation is variable
 Real interest rate
– Real and nominal interest rates do not
– Interest rate corrected for the effects of always move together
inflation
 Periods of deflation
= Nominal interest rate – Inflation rate
– Real interest rate exceeds the nominal
interest rate
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 Figure 4. Real and Nominal Interest Rates

This figure shows nominal and real interest rates using annual data since 1965. The nominal
interest rate is the rate on a three-month Treasury bill. The real interest rate is the nominal
interest rate minus the inflation rate as measured by the CPI. Notice that nominal and real
interest rates often do not move together.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 21
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