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Measuring The Cost of Living (Ch:11 P.O.M.E) : ECO 104 Faculty: Asif Chowdhury

This document discusses measuring the cost of living over time using the Consumer Price Index (CPI). There are three key points: 1. CPI tracks changes in consumer prices and inflation over time. It allows comparison of purchasing power across periods by expressing income levels in terms of a base year. 2. CPI is calculated based on the prices of goods and services in a fixed market basket, though this leads to problems like substitution bias. 3. CPI is preferred over GDP deflator for measuring inflation experienced by consumers, as it focuses on consumer goods while GDP deflator includes all domestic production.

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55 views12 pages

Measuring The Cost of Living (Ch:11 P.O.M.E) : ECO 104 Faculty: Asif Chowdhury

This document discusses measuring the cost of living over time using the Consumer Price Index (CPI). There are three key points: 1. CPI tracks changes in consumer prices and inflation over time. It allows comparison of purchasing power across periods by expressing income levels in terms of a base year. 2. CPI is calculated based on the prices of goods and services in a fixed market basket, though this leads to problems like substitution bias. 3. CPI is preferred over GDP deflator for measuring inflation experienced by consumers, as it focuses on consumer goods while GDP deflator includes all domestic production.

Uploaded by

KaziRafi
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Lecture 2

Measuring The Cost of Living


(Ch:11; P.O.M.E)
ECO 104
Faculty: Asif Chowdhury

An amount earned 10 years back from now


( present time) is not equal to the same amount
earned now. This is because of the difference in
the cost of living between the two periods. In
order to get a measure of the present equivalent
amount of some income level, received in the
past, the income level has to be expressed in
terms of purchasing power. This process is
facilitated by the use of a statistics called CPI
( Consumer Price Index.) CPI can be used to
compare between income levels in two different
time periods.

CPI traces changes in the cost of living &


hence is linked to movement in the price
level. Changes in the general price level is
known as inflation. Inflation rate refers to the
percentage change in the price level from one
period to the next. We have seen previously
that GDP Deflator also provides a measure of
Inflation rate, however CPI is referred over
GDP Deflator for measuring inflation, since CPI
is more representative of consumer purchased
goods & services.

CPI ( Consumer Price Index)


CPI is defined as the measure of the overall cost
of the goods & services bought by a typical
consumer. The relevant statistical division of the
government prepares the CPI. The CPI is used to
compare income from different time periods & to
measure inflation rate. The statistical division
computes the CPI for thousand of goods &
services. Here for simplicity we shall look at two
goods scenario- Banana & Orange. There are five
steps to compute the CPI:
Fix the basket: determine which goods/services
are more valued by the consumer. The
good/services most valued will mean that the
prices of those goods/services are important to

Weights are determined by surveying the


consumers & finding the quantities of those
goods/services, bought by the typical
consumer. In our case of two goods
scenario, if bananas are valued more than
bananas would be assigned higher weight.
Finding the Prices: finding out the prices
of the goods/services included in the
basket. The prices are found for different
points in time ( reflecting different CPI)

Computing the basket cost: using the prices of


the different goods & services the value of the
basket is computed for different points in time.
Choosing the base year & computing the index:
after selecting the base year the CPI indices are
computed relative to the base year value.
Computing the Inflation Rate: after obtaining the
measure of the different CPI indices, the inflation
rate for different periods of time can be
computed using those CPI indices.

Producer Price Index: measures the cost of


a basket of goods & services bought by
firms. The logic behind computing PPI is
that when the producers are facing rising
cost, its eventually transferred on as higher
price & so eventually raises the CPI.
It should be noted that the weight of the
goods/services in the CPI basket doesnt
change. Only the prices are variable so that
changes in the price levels can be captured.

Problems in measuring the


CPI:
Three problems are associated with the CPI
measurement:
Substitution Bias: the weights of the goods/
services are fixed in the basket & doesnt take into
account of consumers switching/ substituting
towards another alternative (e.g.. a cheaper good)
Introduction of new goods: new goods can offer
consumers the option of maintaining the same
standard of living at a relatively lower cost.
However since CPI is based on a fixed basket, these
new goods dont usually show up in the basket.

Unmeasured Quality Change: If a


certain good offers better quality at
the same price, at a later time
period, then the relative price of the
good will be lower. However since
quality is not easy to quantify, the
CPI cant account for quality properly
& hence will be overstated.
Overstating of CPI has implications in
terms of government programs-

Difference between the CPI & GDP


Deflator:
o CPI takes into account of goods & services bought by
consumers. GDP Deflator includes everybody like the
government. CPI takes into account of imported goods
whereas GDP Deflator only includes items produced
domestically. This difference becomes prominent in case of
countries importing oil.
o CPI compares the value of a fixed basket of goods/ services
to the same basket at some benchmark year value. GDP
Deflator compares the price of currently produced goods &
services to the benchmark price of those same goods &
services. When price doesnt change proportionately,
weights attached to different goods/ services matter.
Sometimes these two measures diverge, but in general,
GDP Deflator & CPI tends to move closely.

Comparing Currency figures across


different times:
Amount in todays currency = Amount
in year T currency X (Price level
today/Price level in year T)
o Indexation: The automatic correction by
law or contract of a certain amount for
the effects of inflation.
Complete or partial indexation of wages
Indexation of government program like
Social Security Payment.

Real & Nominal Interest


Rate:
Adjusting
for
effects
of
inflation
has
implications for lending to or borrowing from
the bank. In the case of lending we receive the
return in the future & in case of borrowing we
have to return the money in the future. In
either cases the future value of money can be
different from the present value of money.
o Nominal Interest Rate: reported interest rate
without being corrected for effects of Inflation.
o Real Interest Rate: interest rate corrected for
effects of Inflation.

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