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Measuring The Cost of Living

The document discusses how the Consumer Price Index (CPI) measures changes in the cost of living over time. The CPI identifies a basket of goods and services typically purchased by consumers and tracks price changes. It is used to calculate inflation rates and correct economic variables for inflation. However, the CPI has problems, as it does not account for consumer substitution behavior, new products, or unmeasured quality changes, which can lead it to overstate inflation.

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50 views27 pages

Measuring The Cost of Living

The document discusses how the Consumer Price Index (CPI) measures changes in the cost of living over time. The CPI identifies a basket of goods and services typically purchased by consumers and tracks price changes. It is used to calculate inflation rates and correct economic variables for inflation. However, the CPI has problems, as it does not account for consumer substitution behavior, new products, or unmeasured quality changes, which can lead it to overstate inflation.

Uploaded by

Anik
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Measuring The Cost of Living

Overview
Learn how the Consumer Price Index
(CPI) is constructed.
Calculating Consumer Price Index and
the Inflation Rate.
Problems in measuring the cost of
living.
Correcting economic variables for the
effects of inflation.
Measuring the Cost of Living
Indetermining the cost of living,
Statistics BD first identifies a “market
basket” of goods and services the
typical consumer buys.
Annually, Statistics BD surveys
consumers to determine what they
buy and the overall cost of the goods
and services they buy.
Measuring the Cost of Living
 The Consumer Price Index (CPI) is used to
monitor changes in the cost of living (i.e.
the selected market basket) over time.
When the CPI rises, the typical family has
to spend more dollars to maintain the same
standard of living.
 The goal of the CPI is to measure changes
in the cost of living. It reports the
movement of prices not in dollar amounts,
but with an index number.
What’s in the CPI’s Basket?

Clothing Alcohol
Household
6.6% 4.5% Health
10.0% 4.3%
Recreation
10.4%

Shelter
27.9%
Food
18.0%
Transportation
18.3%
What is an Index Number?
An Index Number is
developed with an
arbitrary base (usually
starting with 100) that
indicates a change in
magnitude relative to
its value at a specified
point in time.
Overview
 Learn how the Consumer Price Index
(CPI) is constructed.
Calculating Consumer Price Index and
the Inflation Rate.
Problems in measuring the cost of
living.
Correcting economic variables for the
effects of inflation.
Calculating the Consumer Price Index
and the Inflation Rate
 Determine what goods are most important
to the typical consumer: Fix the Basket
 Find the prices of each of the goods and
services in the basket for each point in
time: Find the Prices
 Use the data on prices to calculate the cost
of the basket of goods and services at
different times: Compute the Basket’s Cost
 Designate one year as the Base Year, which
is the benchmark for yearly comparison.
Calculating the Consumer Price Index
and the Inflation Rate
 The final step includes using the CPI to
calculate the Inflation Rate, which is:
– the percentage change in the price index
from the preceding period
Example:
– Base Year is 2000
– Bundle of goods in 2000 = $1,200
– The same bundle in 2002 cost = $1,272
– CPI = ($1,272 ÷ $1,200) X 100 = 106
– Prices between 2000 & 2001 increased 6%
Other Price Indexes
Other Price Indexes are computed for:
– Specific regions within the country
(e.g. each District and for 6 cities
across Bangladesh)
– Narrow categories of goods and
services (e.g. food, clothing, etc.)
– Producer costs of resources (i.e.
industrial product price index)
Overview
 Learn how the Consumer Price Index
(CPI) is constructed.
 Calculating Consumer Price Index and
the Inflation Rate.
Problems in measuring the cost of
living.
Correcting economic variables for the
effects of inflation.
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.”
Three reasons/problems:
– Substitution Bias
– Introduction of new goods
– Unmeasured quality change
Problems of CPI: Substitution Bias
The bundle does not change in the
short run to reflect consumer reaction
to changing relative prices.
– Consumers substitute toward goods that
have become relatively less expensive.
– CPI is computed assuming a fixed basket
of goods.
– The index overstates the increase in cost
of living by not considering the
substitution by the consumer.
Problems of CPI: New Goods
The bundle does not reflect the effects
of new products that typically go down
in price after introduction.
– New products result in greater variety,
which in turn makes each dollar more
valuable. Consumers need fewer dollars
to maintain any given standard of living.
– The CPI is based on a fixed basket of
goods and does not reflect the change in
the purchasing power of the dollar.
Problems of CPI: Quality Changes
Higher market prices usually include
quality changes that do not necessarily
represent a higher cost of living.
– If the quality of a good decreases from
one year to the next, the value of a dollar
falls, even if the price of the good stays
the same.
– The true cost of living may be less even
though some goods cost more.
Problems of CPI

The substitution bias, introduction of


new goods, and unmeasured quality
change tends to lead the CPI to
overstate the increase in the cost of
living by about half a percent (.5%)
This measurement error tends to
overstate the “true” cost of living.
The Consumer Price Index
versus the GDP Deflator
The CPI:
– includes only consumption goods
– includes the cost of imports
– is a fixed bundle of goods
The GDP Price Deflator:
– includes all final goods and services
– excludes imports
– uses a current bundle of goods
Quick Quiz!
Explain briefly
what the
consumer price
index is trying to
measure and how
it is constructed.
Overview
 Learn how the Consumer Price Index
(CPI) is constructed.
 Calculating Consumer Price Index and
the Inflation Rate.
 Problems in measuring the cost of
living.
Correcting economic variables for the
effects of inflation.
Correcting Economic Variables for
the Effects of Inflation
Price indexes are used to correct for
the effects of inflation when
comparing dollar figures from different
times.
When some dollar amount is
automatically corrected for inflation by
law or contract the amount is said to
be indexed for inflation.
– e.g., COLA’s and Canada Pension Plan
Correcting Economic Variables for
the Effects of Inflation
To convert (inflate) past wages and
prices into current terms:
Current Year Dollars =
Past Year Nominal Value X [(Price index
in current year) ÷ (Price index in past
year)]
Correcting Economic Variables for
the Effects of Inflation
To convert (deflate) current wages and
prices into past year terms:
Value in Past Year Dollars =
Current Year Value X [(Price index in
past year) ÷ (Price index in current
year)]
Real and Nominal Interest Rates
Interest represents a payment in the
future for a transfer of money in the
past.
Nominal interest rate:
– The rate that the bank pays in current
value.
Real interest rate:
– The interest rate corrected for inflation.
– Real interest rate = Nominal - Inflation
Real and Nominal Interest Rates
Example — Assume:
– You borrow $1,000 for one year.
– Nominal Interest rate was 15%.
– During the year inflation was 10%.
The real interest rate is:
15% - 10% = 5%
Conclusion
When comparing dollar values from
different times, it is necessary to keep
in mind that a dollar today is not the
same as a dollar in the past.
The CPI illustrates one way that prices
are measured and how to make
adjustments for these price changes.
Overview
 Learn how the Consumer Price Index
(CPI) is constructed.
 Calculating Consumer Price Index and
the Inflation Rate.
 Problems in measuring the cost of
living.
 Correcting economic variables for the
effects of inflation.

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