Consumer Price Index, Producer Price Index and GDP on Cost of Living

Before proceeding on the discussion about how consumer price index (CPI), producer price
index (PPI) and GDP considered as an imperfect measures of cost of living, let us define
first the following economic terms.

Definition of Terms

According to Universiti Kebangsaan Malaysia (UKM), consumer price index is a measure of

the overall cost of the goods and services bought by a typical consumer. It is used to
monitor changes in the cost of living over time. When the CPI rises, the typical family has to
spend more dollars to maintain the same standard of living.

Another definition is stated by Investopedia. CPI is a measure that examines the weighted
average of prices of a basket of consumer goods and services, such as transportation, food,
and medical care. It is calculated by taking price changes for each item in the
predetermined basket of goods and averaging them. Changes in the CPI are used to assess
price changes associated with the cost of living. It is one of the most frequently used
statistics for identifying periods of inflation or deflation.

(Inflation refers to a situation in which the economy’s overall price level is rising. The
percentage change in the price level from the previous period is called inflation rate.)

Gregory Mankiw stated in his book “Principles of Economics, Eighth Edition”, consumer
price index is the most closely watched index of prices, but it is not the only such index.
Another is the producer price index. As published by the Bureau of Labor Statistics (BLS), it
is a group of indices that calculates and represents the average movement in selling prices
from domestic production over time.

PPI is different from the CPI in that it measures costs from the viewpoint of industries that
make the products while the CPI measure prices from the perspective of consumers.

Problems in Measuring the Cost of Living

I. Consumer Price Index and Producer Price Index

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. According to UKM, there are three major
problems that justify the imperfect measurement of CPI.

1. Substitution bias

The basket does not change to reflect consumer reaction to changes in relative
prices. Consumer substitute toward goods that have become relatively less
expensive.
 Khan Academy further explains that a fixed, unchanging basket of goods assumes
that consumers are locked into buying exactly the same goods, regardless of price
changes – not very likely assumption.

Thus, substitution bias tends to overstate the rise in a consumer’s true cost of living
because it does not take into account that the person can substitute away from
goods whose relative prices have risen.

2. Introduction of new goods

The basket does not reflect 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.

According to Khan Academy, a new product can be thought of as an extreme

improvement in quality – from something that did not exist to something that does.
However, the basket of goods that was fixed in the past obviously does not include
new goods created since then. The basket of goods and services used in the CPI is
revised and updated over time, so new products are gradually included. But the
process takes some time.

The arrival of new goods creates problems with respect to the accuracy of
measuring inflation as well. The reason why people buy new goods, presumably, is
that the new goods offer better value for money that existing goods. Thus, if the CPI
leaves out new goods, it overlooks one of the ways in which the cost of living is
improving. In addition, the price of a new good is often higher when it is first
introduced and then declines over time. If the new good is not included in the CPI
for some years – until its price is already lower – the CPI may miss counting this
price decline altogether.

3. Unmeasured quality changes

UKM argues that if the quality of a good rises from one year to the next, the value of
a dollar rises, even if the price of the good stays the same. If the quality of a good
falls from one year to the next, the value of a dollar falls, even if the price of the good
stays the same.

Khan Academy elaborates that it would be misleading to count the entire resulting
higher price as inflation because the new price is being charged for a product of
higher – or at least different – quality.

With these arguments presented, the quality/new goods bias means that the rise in
the price of a fixed basket of goods over time tends to overstate the rise in a
consumer’s true cost of living because it does not take into account how
improvements in the quality of existing goods and the invention of new goods
improve the standard of living.
In summary, the substitution bias, introduction of new goods and unmeasured quality
changes cause the CPI to overstate the true cost of living. CPI overstates inflation by about 1
percentage point per year.

The major problems indicated above are also applicable to PPI. Thus, the 3 major problems
presented are the reasons why PPI is an imperfect measure of the cost of living.

II. Gross Domestic Product

According to Khan Academy, GDP is a limited tool for measuring standard of living. The
following points are the reasons why GDP is an imperfect measure of standard of living.

1. GDP does not account for leisure time. In the discussion at World Economic Forum
in Davos, Switzerland, it cited an example wherein we imagine two economies with
identical standards of living, but in one economy the workday averages 12 hours,
while in the other it's only eight.

2. GDP includes what is spent on environmental protection, healthcare, and education,

but it does not include actual levels of environmental cleanliness, health, and
learning. GDP includes the cost of buying pollution-control equipment, but it does
not address whether the air and water are actually cleaner or dirtier. GDP includes
spending on medical care, but it does not address whether life expectancy or infant
mortality have risen or fallen. Similarly, GDP counts spending on education, but it
does not address directly how much of the population can read, write, or do basic
mathematics.

3. GDP includes production that is exchanged in the market, but it does not cover
production that is not exchanged in the market. For example, hiring someone to
mow your lawn or clean your house is part of GDP, but doing these tasks yourself is
not part of GDP.

4. GDP has nothing to say about the level of inequality in society. GDP per capita is only
an average. When GDP per capita rises by 5%, it could mean that GDP for everyone
in the society has risen by 5% or that the GDP of some groups has risen by more
while the GDP of others has risen by less—or even declined.

5. GDP also has nothing in particular to say about the amount of variety available. If a
family buys 100 loaves of bread in a year, GDP does not care whether they are all
white bread or whether the family can choose from wheat, rye, pumpernickel, and
many others—GDP just looks at whether the total amount spent on bread is the
same.

6. GDP has nothing much to say about which technology and products are available.
The standard of living in, for example, 1950 or 1900 was not affected only by how
much money people had—it was also affected by what they could buy. No matter
 how much money you had in 1950, you could not buy an iPhone or a personal
computer.

7. It is not clear that a rise in GDP is even a good thing. If a city is wrecked by a
hurricane and then experiences a surge of rebuilding construction activity, it would
be peculiar to claim that the hurricane was therefore economically beneficial. If
people are led by a rising fear of crime to pay for installation of bars and burglar
alarms on all their windows, it is hard to believe that this increase in GDP has made
them better off.

The fact that GDP per capita does not fully capture the broader idea of standard of living
has led to a concern that the increases in GDP over time are illusory. It is theoretically
possible that while GDP is rising, the standard of living could be falling if human health,
environmental cleanliness, and other factors that are not included in GDP are worsening. In
some ways, the rise in GDP actually understates the actual rise in the standard of living.

A high level of GDP should not be the only goal of macroeconomic policy – or broader
government policy. But, even though GDP does not measure the broader standard of living
with any precision, it does measure production well, and it does indicate when a country is
materially better or worse in terms of jobs and incomes.

Distinction between real and nominal interest rates

According to Investopedia, a real interest rate is an interest rate that has been adjusted to
remove the effects of inflation to reflect the real cost of funds to the borrower and the real
yield to the lender or to an investor. A nominal interest rate refers to the interest rate
before taking inflation into account. Nominal can also refer to the advertised or stated
interest rate on a loan, without taking into account any fees or compounding of interest.
It further explains that real interest rate, unlike nominal rate, factors inflation into the
equation, to give investors a more accurate measure of their buying power, after they
redeem their positions. For example, if an annually compounding bond lists a 6% nominal
yield and the inflation rate is 4%, then the real rate of interest is actually only 2%.

It is feasible for real interest rates to be in negative territory, if the inflation rate exceeds
nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real
interest rate of -1% if the inflation rate is 4%.

For the case of nominal interest rate, it is the stated interest rate of a bond or loan, which
signifies the actual monetary price borrowers pay lenders to use their money. For example,
if the nominal rate on a loan is 5%, borrowers can expect to pay Php 5 of interest for every
Php 100 loaned to them. This is often referred to as the coupon rate, because it was
traditionally stamped on the coupons redeemed by bondholders.

References:
Mankiw, N. G. (2010). Principles of Economics: 7th Edition. Worth Publishers, 41 Madison
Avenue, New York.

Thoma, M. (2016). Why GDP fails as a measure of well-being.

https://www.cbsnews.com/news/why-gdp-fails-as-a-measure-of-well-being/

Universiti Kebangsaan Malaysia. Measuring of Cost of Living.

http://www.ukm.my/hairun/Ecn3100/measuring%20the%20cost%20of%20living.pdf

Khan Academy. How changes in the cost of living are measured.

https://www.khanacademy.org/economics-finance-domain/macroeconomics/macro-
economic-indicators-and-the-business-cycle/macro-limitations-of-gdp/a/how-well-gdp-
measures-the-well-being-of-society-cnx

https://www.khanacademy.org/economics-finance-domain/macroeconomics/macro-
economic-indicators-and-the-business-cycle/macro-price-indices-and-inflation/a/how-
changes-in-the-cost-of-living-are-measured-cnx

https://www.investopedia.com/terms/c/consumerpriceindex.asp

https://www.investopedia.com/terms/p/ppi.asp

https://www.investopedia.com/ask/answers/032515/what-difference-between-real-and-
nominal-interest-rates.asp

https://www.investopedia.com/articles/investing/082113/understanding-interest-rates-
nominal-real-and-effective.asp