Measuring the

Cost of Living
BY C A A B H A DA M M A N I
In this chapter we will see:
 What is Consumer Price Index (CPI)? How is it calculated? What is it used for?
What are the problems with CPI ? How serious are they?
 How does the CPI differ from GDP deflator?
 How can use the CPI to compare amounts from different years? Why would we
want to do this,
anyway?
 How can we correct interest rates for inflation?
THE CONSUMER PRICE INDEX
(CPI)
• The CPI is a measure of the overall cost of the goods and services
bought by a typical customer.

• Producer Price Index also known as Wholesale Price Index : It is a measure of

the cost of basket of goods and services bought by firms.
 How the CPI is calculated?

 FIX THE BASKET:

Determine which prices are most important to the typical consumers. The greater weight
should be given to the commodities in higher consumption by the typical consumers. There are
surveys conducted to determine what’s in the typical consumer’s “shopping basket”.
 FIND THE PRICES:
Find the prices of each of the goods and the services in the basket at each point of time. The
survey conducted also collects data on the prices of all the goods in the basket.

 COMPUTE THE BASKET’s COST:

Use the data on prices to calculate the cost of the basket of goods and services at different
times.
 How the CPI is calculated?

 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.
THE CPI IN ANY YEAR EQUALS TO:

Cost of Basket in Current year

100 x ------------------------------------------
Cost of Basket in Base Year

 COMPUTE THE INFLATION RATE:

The percentage change in the CPI from the preceeding period.
INFLATION RATE:
CPI this year-CPI last year
---------------------------------- x 100
CPI last year
 EXAMPLE
(BASKET : 4 DOUGNUTS, 10 ICED TEA)

YEAR PRICE OF PRICE OF ICED TEA Cost of Basket

DOUGHNUT
2007 100 50 100x4+50x10= 900
2008 110 60 110x4+60x10=1,040
2009 120 70 120x4+70x10=1,180

Compute CPI in each year using 2007 as the base year.

2007: 100 x (900/900) =100 115-100

15% = ----------- x 100
100
2008: 100 x (1,040/900) =115 131-115
13.91% = ---------- x 100
2009: 100 x (1,180/900) =131 115
 PROBLEMS WITH THE CPI
Substitution Bias

 Substitution Bias : When consumers choose to substitute one good for another
after its price becomes cheaper than the good they normally buy.
 Over time, some prices rise faster than others. All prices when changed from
one year to the next, they do not all change proportionately.
 Consumers substitute toward goods that become relatively cheaper, mitigating
the effects of price increases.
 The CPI misses this substitution because it uses a fixed basket of goods.
 Thus, the CPI overstates the cost of living.
 PROBLEMS WITH THE CPI
Introduction of New Goods
 The Introduction of new goods increases variety, allows consumers to find
products that more closely meet their needs.
Consumers have more variety from which to choose and this in turn reduces the
cost of maintaining the same level of economic well being.
 In effect, money becomes more valuable.
The CPI misses this effect of increase in the value of money that arises from
introduction of new goods because it uses a fixed basket of goods.
Thus, the CPI overstates the cost of living.
 PROBLEMS WITH THE CPI
Unmeasured Quality Change
 Improvements in the quality of goods in the basket increase the value of the
money.
 The Bureau of Labour Statistics (BLS) or the Labour Bureau tries to account for
quality changes but probably misses some, as quality is hard to measure.
 Thus, the CPI overstates the cost of living.
 If quality deteriorates from one year to another with same price, the value of
money falls and vice versa.
 PROBLEMS WITH THE CPI
 The goal of CPI is to measure changes in the cost of living. In other words, the CPI
tries to gauge how much incomes must rise to maintain a constant standard of living.
 The CPI however is not a perfect measure of the cost of living.
 Each of these problems causes the CPI to overstate cost of living .
 Several studies during 1990 concluded that CPI overstated inflation by 1 percent per
year. The BLS adopted several technical adjustments to improve the CPI, but the CPI
still overstates inflation by about 0.5 percent per year.
 The issue is important as many government programs use CPI to adjust the changes
in the overall level of prices.
Recipients of Social Security, get annual increases in the benefits that are tied to CPI.
 CPI Vs. GDP Deflator
Economists and Policy Makers monitor both GDP Deflator and the CPI to gauge how quickly the prices are
rising. Usually these two statistics tell similar story.
Yet there are certain important differences that can cause them to diverge:
• The First difference is GDP deflator reflects the prices of all goods and services produced domestically,
whereas the CPI reflects the prices of all goods and services bought by the consumers.
For example:
 Suppose that the price of an airplane produced by the Boeing and sold to Air Force rises. Even though the
plane is the part of the GDP, it is not part of the basket of goods and services bought by typical consumer.
Thus, the price increase shows up in the GDP Deflator but not in the CPI.
 Cars which are imported are not part of the GDP deflator but will be a part of CPI. Its an imported
consumption good.
 This particular difference between the two is important when the prices of Oil changes. Oil products are
much larger share of the consumer spending than of GDP. So CPI rises by much more than GDP deflator.
 CPI Vs. GDP Deflator
• The second difference between the two concerns how various prices are weighted to yield a
single number for the overall level of prices.
•The CPI compares the price of a fixed basket of goods and services to the price of the basket in
the base year. Only occasionally the bureau change the basket of goods.
• By contrast, 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, group of goods and services used to
compute GDP deflator changes automatically over time.
• This difference is not important when all prices are changing proportionately.
•But if the prices of different goods and services are changing by varying amounts, the way we
weight the various price matters for the overall inflation rate.
 Correcting Variables for Inflation
Comparing dollar figures from different times

 Inflation makes it harder to compare dollar amounts from different times.

 The formula for turning dollar figures from Year T into today’s dollars is the following:
Price level today
Amount in today’s dollars = Amount in year T dollars x------------------------
Price level in Year T
 Lets take an example of Ruth’s Salary:
Was his salary of $ 80,000 high in 1931 or low compared to the salaries of today’s players?
For this, we need to know the level of prices in 1931 and level today.

To compare Ruth’s Salary to those of today’s players, we need to inflate Ruth’s salary to turn
1931 dollars into todays dollars.
 Correcting Variables for Inflation
Comparing dollar figures from different times

 A price index such as the CPI measures the price level and thus determines the size of the
inflation correction.
 Let’s apply this formula to Ruth’s salary. Government Statistics show a CPI of 15.2 in 1931 and
214.5 for 2009. Thus, the overall level of prices has risen by a factor of 14.1 (which equals
214.5/15.2). We can use these numbers to measure Ruth’s salary in 2009 dollars, as follows:
Salary in 2009 dollars = Salary in 1931 dollars x Price level in 2009
Price level in 1931
= $80,000 x 214.5
15.2
= $1,128,947
 Correcting Variables for Inflation
Comparing dollar figures from different times

 Researchers, business analysts and policy makers often use this technique to convert a time
series of Current dollar (nominal) figures into constant dollar (real) figures.
 They can see how a variable has changed overtime after correcting for inflation.
 Correcting Variables for Inflation
Indexation
 As we have seen, prices indexes are used to correct for the effects of inflation when comparing
dollar figures from different times.
 This type of correction is shown up in many places in the economy.
 When some amount is automatically corrected for changes in the price level by law, the amount
is said to be indexed for inflation.
 For eg, many long term contracts between firms and unions include partial or complete
indexation of the wage to the CPI. Such Provision is called a cost of living allowance, or COLA.
 Indexation is also a feature of many laws.
 Brackets of tax rates are also indexed for inflation.
 Correcting Variables for
Inflation
Real and Nominal Interest Rates
 The nominal interest rates :
The interest rate not corrected for inflation
The interest rate that measure the changes in value is nominal interest rate.
 Real Interest rate:
The rate corrected for inflation is the real interest rate.
So the nominal interest rate real interest rate and inflation rate are related approximately as
follows:
REAL INTEREST RATE = NOMINAL INTEREST RATE- INFLATION RATE
 Nominal Interest rate tells you how fast the number of dollars in your bank account rises while the
real interest rate tells you how fast the purchasing power of your bank account rises over time.
 Example:
 Sally a movie fan Deposit $ 1000 for one year at an annual interest rate of 10%. She buys DVDs to
watch movie.
 Nominal Interest rate 10%
 During that year , inflation is 3.5%
 RIR = NIR – IR
= 10% - 3.5%
=6.5%
 The purchasing power of the $ 1000 deposit has grown up by 6.5%.
 Zero Inflation : 10% increase in her purchasing power
 6% Inflation: 4 % increase in her purchasing power
 10% Inflation: Same purchasing power as of last year
 12% Inflation: 2% Decrease in the Purchasing power
 2% deflation: 12% increase in her purchasing power.
 CASE STUDY

 The graph shows the real and nominal interest rates from 1950 -2010 in the US
Economy.

 One feature of this figure is that nominal interest rate almost always exceeds the
real interest rate. This reflects the fact that the US economy has experienced
rising consumer prices in almost every year during this period. By contrast if you
look at the data of US economy during the late 19th century or for the Japanese
economy in some real recent years, you will find periods of deflation.
 During deflation the real interest rates exceed the nominal interest rates.
 Another feature of the graph, as inflation is variable, real and nominal interest
rates do not always move together.
THANK YOU