MEASURING THE COST OF

LIVING/PRICE LEVEL
 Agenda
 Definition of Consumer Price Index (CPI)
 Calculation of CPI
 Composition of CPI basket
 Other Indices: PPI, GDP deflator
 Limitations of CPI
 Uses of CPI
 Definition
 Consumer price index (CPI):
• measures
 overall cost of the goods and services bought by a
typical consumer
 1/purchasing power of money
CALCULATING CPI
1. Fix the basket: TUIK determines a
representative bundle of goods and services
purchased by a typical consumer.

Example: 4 breads and 2 bottles of milk

2. Find the prices for each year

Example:
Year Price of bread Price of milk
2001 $1 $2
2002 $2 $3
2003 $3 $4
3. Compute the basket’s cost.

Example:
Cost in 2001 = ($1 × 4) + ($2 × 2) = $8.
Cost in 2002 = ($2 × 4) + ($3 × 2) = $14.
Cost in 2003 = ($3 × 4) + ($4 × 2) =$20
4. Choose a base year and compute the
index

Example: (using 2001 as the base year):

CPI for 2001 = ($8)/($8) × 100 = 100.
CPI for 2002 = ($14)/($8) × 100 = 175.
CPI for 2003 = ($20)/($8) × 100 = 250.
5. Compute the inflation rate (the percentage
change in the price index from the preceding
period.)

Example:
Inflation Rate for 2002 = (175 – 100)/100 × 100% = 75%.
Inflation Rate for 2003 = (250 – 175)/175 × 100% = 43%

Can the inflation rate ever be negative?

 Turkey’s Yearly Inflation Rate
120

100

80

60

40

20

0
3 9 43 47 51 55 59 63 67 71 75 79 (1) (1) 91 95 99 03 07
19 19 19 19 19 19 19 19 19 19 19 983 987 19 19 19 20 20
-20 1 1
COMPOSITION OF THE
BASKET
The Makeup of the Consumer Price
Index- U.S.
Main Groups for Consumer Price
Index - Turkey (current weights)

https://www.drdatastats.com/2020-tuik-enflasyon-sepeti/
https://biruni.tuik.gov.tr/medas/?kn=136&locale=en
OTHER INDICES
 The Producer Price Index

 a measure of the cost of a basket of

goods and services bought by firms.
• Leading indicator for CPI
140
Yearly Inflation(CPI-PPI)
120

100

80

60

40

20

0
3 9 43 47 51 55 59 63 67 71 75 79 (1) (1) 91 95 99 03 07
19 19 19 19 19 19 19 19 19 19 19 983 987 19 19 19 20 20
-20
1 1
-40

CPI WPI
GDP Deflator vs. CPI
 The GDP deflator is calculated as follows:

N o m in al G D P
G D P d eflato r =  100
R eal G D P
The GDPare
There Deflator versus the
two important Consumer
differences
Price IndexCPI and GDP deflator
between
• The CPI basket is fixed (changes every
decade or so) whereas GDP deflator basket
changes every year (includes whatever is
produced that year)
• CPI reflects the prices of all goods and
services bought by consumers whereas GDP
deflator reflects the prices of all goods and
services produced domestically
The CPI, the PPI, and the GDP Deflator for the
U.S

26
PROBLEMS WITH CPI
Problems in Measuring the Cost of Living

 Substitution bias
 Unmeasured quality changes
 Introduction of new goods
 Substitution Bias
Problems
• When thein Measuring
price the Cost
of one good changes, of Living
consumers often
respond by substituting another good in its place.
• The CPI does not capture this; it is calculated using a fixed
basket of goods and services.
• This implies that the CPI overstates the increase in the cost
of living over time.
 Example:
• 2 goods: coke and pepsi.
• In a typical consumer basket 10 cokes and 10 pepsis
• 2009
 Same price 1 YTL
 Cost of a typical basket?
• 2010
 Price of coke becomes 2 YTL, price of pepsi stays at 1 YTL
 Cost of typical basket?
• Measured inflation?
• Does it reflect the true increase in cost of living?
Problems in Measuring
 Unmeasured the Cost of Living
Quality Changes
• If the quality of a good falls from one year to
the next, the value of a money falls; if quality
rises, the value of the money rises.
• Example:
 Improvements in the quality of computers over the
years
 Introduction of New Goods
Problems in Measuring
• The basket the Cost
does not reflect of Living
the change in
purchasing power brought on by the
introduction of new products.
 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
Problems
The substitution bias, the
in Measuring introduction of new
Cost of Living
goods, and unmeasured quality changes
cause the CPI to overstate the true cost of
living.
• The issue is important because many
government programs use the CPI to adjust
for changes in the overall level of prices.
• The CPI overstates inflation by about 1
percentage point per year.
USES OF CPI
 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.
 Question: Babe Ruth earned 80000 dollars
in 1931. How much does that make in
2021 dollars?
 Do the following to convert (inflate) Babe
Ruths wages in 1931 to dollars in 2021:
• CPI for 1931=15.2
• CPI for 2021=237
• So his wage in 2021 dollars it is
 (80000/15.2)*237= 1,247,368 dollars
 Inflation allows calculating real interest
rate
• The nominal interest rate is the interest rate
usually reported and not corrected for
inflation.
 It is the interest rate that a bank pays.
• The real interest rate is the nominal interest
rate that is corrected for the effects of
inflation.
 Real interest rate= Nominal Interest Rate-Inflation
Real and Nominal Interest Rates

 You borrowed $1,000 for one year.

 Nominal interest rate was 15%.
 During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
= 15% - 10% = 5%
Indexation
CPI allows for indexation
• When some dollar amount is automatically
corrected for inflation by law or contract, the
amount is said to be indexed for inflation.
• Wages, bonds are indexed to inflation