4/6/2023

ECO 121: ELEMENTARY MACROECONOMICS

LECTURE 3: MEASURING COST OF LIVING

Winford Masanjala

Learning Objectives
LO1 Explain how the consumer price index (CPI) is constructed and use
it to calculate the inflation rate.
LO2 Show how the CPI is used to adjust dollar amounts to eliminate the
effects of inflation.
LO3 Discuss the two most important biases in the CPI.
LO4 Distinguish between inflation and relative price changes in order
to find the true costs of inflation.
LO5 Summarize the connections among inflation, nominal
interest rates, and real interest rates.

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MEASURING THE COST OF LIVING

• The consumer price index (CPI) is the basic tool for measuring changes in
the cost of living (inflation).

• CPI Measures the cost of a standard basket of goods and services relative
to the cost of the same basket of goods and services in a base year.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑌𝑒𝑎𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡

𝐶𝑃𝐼𝑡 =
𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡

MEASURING COST OF LIVING

Steps In Measuring Cost of Living
1. Fix the basket: Requires deciding which goods are important to the typical
consumer.
2. Find the prices: For each good in the basket find the price at each point in
time.
3. Use 1 and 2 to compute the cost of the basket at all points in time.
4. Choose a base year and compute the CPI.
5. Use the CPI to compute the inflation rate:

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MEASURING COST OF LIVING

The inflation rate is the percentage change in the price index from the
proceeding period.

𝑪𝑷𝑰𝒕 −𝑪𝑷𝑰𝒕−𝟏
𝝅𝒕 = 𝒙100
𝑪𝑷𝑰𝒕−𝟏

Ex. A student at UNIMA consumes three good/services.

accommodation, food and internet.

Ex. UNIMA Student Basket

2015 2020
Item
Month Year Month Year

Rent 15,000 150,000 20,000 200,000

Food 10,000 100,000 15,000 150,000

Internet 5,000 50,000 7,500 75,000

Total 300,000 425,000

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Ex. UNIMA Student Basket

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐵𝑎𝑠𝑘𝑒𝑡20
𝐶𝑃𝐼2020 = 𝑥100
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐵𝑎𝑠𝑘𝑒𝑡15

425,000
𝐶𝑃𝐼2020 = 𝑥100 = 141.7
300,000

Since 2015, prices of a typical basket of goods for a UNIMA student

have cumulatively risen by 41.7 percent

Ex 2. CPI & INFLATION IN THE USA

The following represent the CPI in the United States. Calculate Inflation rate
for 2003-04 and 2004-05

Year CP1
2003 1.840
2.26
2004 1.889
3.39
2005 1.953

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Ex 2. CPI AND INFLATION IN THE USA

𝑪𝑷𝑰𝟎𝟒 − 𝑪𝑷𝑰𝟎𝟑 𝟏. 𝟖𝟖𝟗 − 𝟏. 𝟖𝟒𝟎

𝝅𝟎𝟒 = 𝒙𝟏𝟎𝟎 = 𝒙𝟏𝟎𝟎 = 𝟐. 𝟕 %
𝑪𝑷𝑰𝟎𝟑 𝟏. 𝟖𝟒𝟎

𝑪𝑷𝑰𝟎𝟓 −𝑪𝑷𝑰𝟎𝟒 𝟏.𝟗𝟓𝟑−𝟏.𝟖𝟖𝟗

𝝅𝟎𝟓 = 𝒙𝟏𝟎𝟎 = 𝒙𝟏𝟎𝟎 = 𝟑. 𝟒 %
𝑪𝑷𝑰𝟎𝟒 𝟏.𝟗𝟓𝟑

Ex 2. CPI AND INFLATION IN THE USA

Ex. Derive the inflation rate for the US during the Great Depression

Year CPI .

1929 0.171
-2.34
1930 0.167
-8.89
1931 0.152
-9.87
1932 0.137

Deflation refers to a situation in which the prices of most goods and services
are falling over time so that inflation is negative

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USES OF THE CPI

USE OF CPI

The CPI is an extremely useful tool in two ways:

1. CPI allows us to measure the cost of living
2. CPI can be used to adjust economic data to eliminate the effects of
inflation. This involves
• Deflating Nominal Quantities, or
• Indexing nominal quantities to maintain real value

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Adjusting for Inflation - Deflating

Recall the difference between nominal and real quantities

• Nominal Quantity: Quantity measured in terms of current money prices.

• Real Quantity: Quantity measured in physical terms.

• Reflects real purchasing power of a nominal quantity

The CPI is used to deflate a nominal quantity to get the real quantity

Adjusting for Inflation - Deflating

Deflating the process of dividing a nominal quantity by price index (e.g. CPI)
to express the quantity in real terms

Nominal Quantityt
Real Quantityt =
CPIt

Ex. The CPI can be used to deflate nominal wages to get real wages

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Adjusting for Inflation - Deflating

• Nominal Wage is the “normal” wages paid to workers measured in

current money units
• Real wage is the wage paid to workers measured in terms of purchasing
power
• The real wage for any given period is calculated by dividing the nominal
(dollar) wage by the CPI for that period

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒𝑠
𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒𝑠 =
𝐶𝑃𝐼

Adjusting for Inflation - Deflating

Example. Suppose we know that the typical family in rural America had a
total income of $40,000 in 2015 and $44,000 in 2020.

• Was this family economically better off in the year 2020 than in 2015?

• Although nominal income has risen, we can only answer if we know

how prices changed over the same period

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Adjusting for Inflation - Deflating

• Suppose in 2015 the CPI was 1.00 and in 2020 the CPI was 1.25. Was this
family better or worse off in 2020?

• We need to compare real income for the two years

Year Nominal Income CPI Real Income

2015 $40,000 1.00 40,000/1.00 =40,000
2020 $44,000 1.25 44,000/1.25 =35,000

Adjusting for Inflation - Indexing

The consumer price index also can be used to convert real quantities to nominal
quantities.
Indexing is the practice of increasing the nominal quantity each period by an
amount equal to % change in price index (inflation rate) to maintain its real value.
• Prevents purchasing power of the nominal quantity from being eroded by
inflation
• Applied in labor contracts for cost of living adjustment (COLA)

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦𝑡+1 = Nominal 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦𝑡 ∗ 𝐶𝑃𝐼𝑡+1

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Adjusting for Inflation - Indexing

• Ex. A Graduate earns K300,000 /month. A labour contract stipulates that
the nominal salary will rise by the percentage increase in CPI.
• If the CPI is 1.05 in year 2 and 1.10 in year 3, what should the nominal wages
be in year 2 and year 3

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒𝑦𝑒𝑎𝑟 2 = 300,000𝑥1.05 = 315,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒𝑦𝑒𝑎𝑟 3 = 300,000𝑥1.10 = 330,000

Price Level Vs Relative Prices

• Its important to distinguish between relative prices and price level.

• The Price level is a measure of the overall level of prices at a particular point in
time as measured by price index.

• The Relative Price refers to the price of specific good or service in comparison to
the price of other goods and services.

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Price Level Vs Relative Prices

Example. Suppose the CPI evolved as follows

Year CPI
2018 1.20
2019 1.32
2020 1.4

• Further suppose that maize prices increased by 8% per year in 2018-19 and
2019-20

Price Level Vs Relative Prices

• In 2018-19 all prices (CPI) rose by 10% while maize prices rose by 8%

⇒ relative price of maize fell by 2% (i.e. 8 – 10 = -2%)

• in 2019-20 inflation rate was 6% while maize prices rose 8 %

⇒ relative price of maize rose by 2%

Note:
• It is possible for price level to remain stable while relative prices are
changing.
• Some goods price rise may be counter-balanced by price falls for others

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THE COST OF INFLATION

1. Noise In The Price System

• Prices transmit information and market signals reflecting supply and

demand

• High inflation distorts price mechanisms because sellers don’t know

whether they are reacting to high demand or just general rise in price.

⇒ Equilibrium is distorted.

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2. Distortion In Tax System

Tax systems can be regressive or progressive
Regressive Tax System is where as income increases the tax rate falls
Progressive tax are systems people with higher income pay higher tax rates.
⇒ If the tax system is not indexed this may lead to “Bracket Creep”
• A situation where an inflation that raises people’s nominal incomes force
one into a higher tax bracket
• Tax payer may pay increasing percentage of their income in taxes, even
though their real incomes may not have increased

3. Shoe-leather Costs

• Inflation raises the cost of holding cash to consumers and businesses

• When faced with inflation people will take actions to try to minimize
loss of purchasing power and “economize” on their cash holdings.
• Shoe-leather costs refer to the cost of economizing on cash, therefore,
going to the bank many times.

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4. Unexpected Redistribution Of Wealth

• The effect of the inflation is not to destroy purchasing power but to

redistribute it
• When inflation is unexpected, it may arbitrarily redistribute wealth from
one group to another
• High inflation hurts workers (wage earners) to the benefit of employers.
• Higher than expected inflation hurts lenders but benefit borrowers.

5. Interference With Long-run Planning

• Many economic decisions take place within a long time horizon.

• Planning for retirement may begin when workers are in their twenties or
thirties.

• Firms develop long-term investment and business strategies that look

decades into the future

• High and erratic inflation can make long-term planning difficult.

• People find it difficult to forecast prices over long period when there’s
inflation.

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Ex. Hyper Inflation

Hyperinflation refers to a situation in which the inflation rate is extremely high.

Year Country Inflation Rate Doubling time for

prices
1923 Germany 102,000,000 3.7 days
1990s Yugoslavia 3.13 x 108 1.4 days)
2009 Zimbabwe 1 billion + 24.7 hrs
1945 Hungary 3.8 x 1027 % 15 hrs

Inflation and Interest Rate

Observation: Whenever inflation is high, interest rates tend to be high as

well. Why?

Nominal Interest Rate(i) is the annual percentage change in the nominal

value (or dollar value) of a financial asset.

• Also called market interest rate

Real interest (r) the annual percentage change of the purchasing power of
a financial asset.

• Real interest measures real rate of return.

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Inflation and Interest Rate

The real interest is calculated as difference between nominal interest and

inflation rate
r=i - π
Ex. Suppose in Malawi the interest rate on savings is 12% but inflation rate
is 26 %. What is the real interest rate?
r = 12 – 26 = -14%
In other words, at the current inflation rate, savings are actually losing 14%
of their value annually.

Inflation and Interest Rate

People have observed that interest rates seem to move together with inflation rate.
It appears that to hedge against loss of value, banks choose to fix the spread between
nominal interest and inflation (real interest )

The tendency for interest rates to be high when inflation is high is called the Fisher
Effect.

Other ways of hedging financial instrument against inflation

• Using variable interest rate to adjust nominal interest as inflation changes to avoid
value erosion by inflation.

• Indexing financial instruments to inflation.

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DOES THE CPI MEASURE “TRUE” INFLATION?

The CPI may overstate the true inflation for two potential biases
1. Quality adjustment bias Occurs when statisticians cannot always adjust
adequately for changes in the quality of goods and services in the basket.
• Some price rises may in fact reflect changes in quality of the goods

2. Substitution bias occurs when statisticians use a fixed basket when people can
easily substitute goods whose prices are rising.
• The basket has goods that are no longer being consumed in the same amounts
• It exaggerates the true increase in the cost of living

Difference between GDP Deflator & Consumer

Price Index
Both the deflator and CPI can be used to derive the rate of inflation. However
they differ in two major respects
1. Coverage
• The GDP deflator reflects average price of all goods and services produced by
the whole economy
• CPI reflects average price of all goods and services bought by typical
consumer.

Ex. If prices of Tobacco and Cotton rises ⇒ GDP deflator will rise but not CPI

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Deference between GDP Deflator & Consumer

Price Index
2. But both measures are relative
• CPI measures the price of a fixed basket of goods and services relative
to price of same basket in a base year.
• GDP deflator measures the price of currently produced good and
services relative to the price of same goods in a base year.

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Institutional Arrangement For National Income

Accounting In Malawi
The National Accounts and Balance of Payments Committee ccordinates
measurement of different variable

1. Ministry of Finance – Fiscal Sector

2. Department of Economic Planning – Real Sector
3. The Reserve Bank (RBM) – Monetary Sector
4. The National Statistical Office (NSO) – Inflation, Balance of Payments

Note
• Both the RBM and NSO have inflation models.
• Under the law, the NSO is the official reporter of inflation.

Institutional Arrangement For National Income

Accounting In Malawi
Procedure for deriving GDP

1. The NABOP choose a Base Year

2. They update supply-and-use tables capturing structure of economy
3. NABOP conducts Business Interviews with companies (twice a year)
4. NABOP uses the business interviews with supply-and-use tables to project
economy

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