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Macroeconomics: Measuring The Cost of Living

The document discusses how economists measure inflation and changes in the cost of living using the Consumer Price Index (CPI). The CPI tracks the prices of goods and services in a set basket over time. It compares the current cost of the basket to the cost in a base year to calculate the inflation rate. However, the CPI has limitations because it does not account for consumers substituting goods when prices change or the introduction of new products.

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191 views11 pages

Macroeconomics: Measuring The Cost of Living

The document discusses how economists measure inflation and changes in the cost of living using the Consumer Price Index (CPI). The CPI tracks the prices of goods and services in a set basket over time. It compares the current cost of the basket to the cost in a base year to calculate the inflation rate. However, the CPI has limitations because it does not account for consumers substituting goods when prices change or the introduction of new products.

Uploaded by

Md Mehedi Hasan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Macroeconomics

ECN 2214

Lecture 3

Measuring the Cost of Living

Musharrat Shabnam Shuchi


Lecturer, Dept. of Economics, UIU
Consumer price index

• The consumer price index is used to monitor changes in the cost of


living over time.

• When the consumer price index rises, the typical family has to spend
more money to maintain the same standard of living.

• Economists use the term inflation to describe a situation in which the


economy’s overall price level is rising. The inflation rate is the percentage
change in the price level from the previous period. The consumer price
index better reflects the goods and services bought by consumers, it is the
more common measure of inflation.
• The consumer price index (CPI) is a measure of the overall cost of the
goods and services bought by a typical consumer.

• How the Consumer Price Index Is Calculated

let’s consider a simple economy in which consumers buy only two


goods: hot dogs and hamburgers:

Step 1: Fix the basket:

Determine which prices are most important to the typical consumer. If


the typical consumer buys more hot dogs than hamburgers, then the price
of hot dogs is more important than the price of hamburgers and therefore,
should be given greater weight in measuring the cost of living.
 Step 2: Find the prices:

Find the prices of each of the goods and services in the basket at each point
in time.

 Step 3: Compute the basket’s cost:

Use the data on prices to calculate the cost of the basket of goods and
services at different times.

Step 4: Choose a base year and compute the index:

Designate one year as the base year, the benchmark against which other
years are compared. (The choice of base year is arbitrary, as the index is used
to measure changes in the cost of living.) Once the base year is chosen, the
index is calculated as follows:
• That is, the price of the basket of goods and services in each year is
divided by the price of the basket in the base year, and this ratio is then
multiplied by 100. The resulting number is the consumer price index.

 Step 5: Compute the inflation rate:

Use the consumer price index to calculate the inflation rate, which is the
percentage change in the price index from the preceding period. That is, the
inflation rate between two consecutive years is computed as follows:
Problems in Measuring the Cost of Living

The goal of the consumer price index is to measure changes in the cost of
living. In other words, the consumer price index tries to measure how much
incomes must rise to maintain a constant standard of living.

The consumer price index, however, is not a perfect measure of the cost of
living. There are three problems in measuring the CPI:

Substitution bias:

When prices change from one year to the next, they do not all change
proportionately: Some prices rise more than others. Consumers respond to
these differing price changes by buying less of the goods whose prices have
risen by relatively large amounts and by buying more of the goods whose
prices have risen less. That is, consumers substitute toward goods that have
become relatively less expensive.
If a price index is computed assuming a fixed basket of goods, it ignores the
possibility of consumer substitution and, therefore, overstates the increase in
the cost of living from one year to the next.

Example:

• Suppose, in the base year apples are cheaper than pears, so consumers buy
more apples than pears.
• When basket of good is constructed for CPI calculation it will include more
apples than pears.

• Now suppose that, in the next year pears are cheaper than apples.
• Consumers will naturally respond to the price changes by buying more pears
and fewer apples.
• Computing CPI using a fixed basket, assumes that consumers continue
buying the now expensive apples in the same quantities as before.

For this reason, the index will measure a much larger increase in the cost
of living than consumers actually experience.
Introduction of New Goods:

When a new good is introduced, consumers have more variety from which to
choose, and this in turn reduces the cost of maintaining the same level of
economic well-being.

Unmeasured quality change

If the quality of a good deteriorates from one year to the next while its price
remains the same, the value of a dollar falls, because you are getting a lesser
good for the same amount of money.

Similarly, if the quality rises from one year to the next, the value of a dollar rises.
Changes in quality remain a problem because quality is so hard to measure.
The GDP Deflator versus the Consumer Price Index

Economists and policymakers monitor both the GDP deflator and the
consumer price index to gauge how quickly prices are rising. Usually, these
two statistics tell a similar story. Yet two important differences can cause
them to diverge.

• GDP deflator reflects the prices of all goods and services produced
domestically.

The consumer price index reflects the prices of all goods and services
bought by consumers.

Example:
• The price of an airplane produced by Boeing and sold to the Air Force
rises. Even though the plane is part of GDP, it is not part of the basket of
goods and services bought by a typical consumer. Thus, the price increase
shows u in the GDP deflator but not in the consumer price index.
• Suppose that Volvo raises the price of its cars. Because Volvos are made
in Sweden, the car is not part of U.S. GDP. But U.S. consumers buy
Volvos, so the car is part of the typical consumer’s basket of goods. Hence,
a price increase in an imported consumption good, such as a Volvo, shows
up in the consumer price index but not in the GDP deflator.

• The GDP deflator compares the price of currently produced goods


and services to the price of the same goods and services in the base year.
Thus, the group of goods and services used to compute the GDP deflator
changes automatically over time.

The consumer price index compares the price of a fixed basket of


goods and services to the price of the basket in the base year.

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