Chapter 05 Measuring The Cost of Living PDF

2/13/2020
N. Gregory Mankiw In this chapter,

look for the answers to these questions:
Principles of
Macroeconomics • What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI?
11 • How does the CPI differ from the GDP deflator?
• How can we use the CPI to compare dollar
amounts from different years? Why would we
Measuring the Cost of want to do this, anyway?
Living Premium • How can we correct interest rates for inflation?
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© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as Ron Cronovich © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Consumer Price Index (CPI) The Consumer Price Index (CPI)
 A measure of the weighted average of prices of a  Bangladesh Bureau of Statistics (BBS)
representative basket of consumer goods and estimates the CPI of representative rural and
services. urban households of the economy on a monthly
 It is calculated by taking prices for each of the item basis and thus reports three sets of CPIs:
in the basket and then averaging them by their  national,
respective weights in the consumption basket.  rural and
 The CPI is an index and not a value in terms of  urban
money because it is expressed as a percentage of
what the market basket costs in a base period.
 Measures the typical consumer’s cost of living
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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How the CPI Is Calculated How the CPI Is Calculated

4. Choose a base year and compute the index.
1. Fix the “basket.”
The CPI in any year equals
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical cost of basket in current year
consumer’s “shopping basket.” 100 x
cost of basket in base year
2. Find the prices.
The BLS collects data on the prices of all the 5. Compute the inflation rate.
goods in the basket. The percentage change in the CPI from the
preceding period.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the Inflation CPI this year – CPI last year
= x 100%
basket. rate CPI last year
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How the CPI Is Calculated EXAMPLE basket: {4 pizzas, 10 lattes}
price of price of
year cost of basket
pizza latte
2010 $10 $2.00 $10 x 4 + $2 x 10 = $60
2011 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2012 $12 $3.00 $12 x 4 + $3 x 10 = $78
using 2010 base year:

Inflation rate:
Compute CPI in each year
2010: 100 x ($60/$60) = 100 115 – 100
15% = x 100%
100
2011: 100 x ($69/$60) = 115
130 – 115
13% = x 100%
2012: 100 x ($78/$60) = 130 115
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ACTIVE LEARNING 1 ACTIVE LEARNING 1

Calculate the CPI price price of Answers price price of
CPI basket: of beef chicken CPI basket: of beef chicken
{10 lbs beef, {10 lbs beef,
2010 $4 $4 2010 $4 $4
20 lbs chicken} 20 lbs chicken}
2011 $5 $5 2011 $5 $5
The CPI basket cost $120 The CPI basket cost $120
in 2010, the base year. 2012 $9 $6 in 2010, the base year. 2012 $9 $6
A. Compute the CPI in 2011, 2011 and 2012. A. Compute the CPI in 2011:
B. What was the CPI inflation rate from 2010-2011 Cost of CPI basket in 2011
and 2011–2012? = ($5 x 10) + ($5 x 20) = $150
CPI in 2011 = 100 x ($150/$120) = 125

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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ACTIVE LEARNING 1 Problems with the CPI:

Answers price price of Substitution Bias
CPI basket: of beef chicken  Over time, some prices rise faster than others.
{10 lbs beef,
2010 $4 $4  Consumers substitute toward goods that become
20 lbs chicken}
2011 $5 $5 relatively cheaper, mitigating the effects of price
The CPI basket cost $120 increases.
in 2010, the base year. 2012 $9 $6
 The CPI misses this substitution because it uses
B. What was the inflation rate from 2011–2012? a fixed basket of goods.
Cost of CPI basket in 2012  Thus, the CPI overstates increases in the cost of
= ($9 x 10) + ($6 x 20) = $210 living.
CPI in 2012 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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Substitution bias Answers
CPI basket: CPI basket:
cost of CPI cost of CPI
{10# beef, beef chicken {10# beef, beef chicken
basket basket
20# chicken} 20# chicken}
2010 $4 $4 $120 2010 $4 $4 $120
2010–11: Household
2011 $5 $5 $150 basket in 2012: 2011 $5 $5 $150
Households
bought CPI basket. 2012 $9 $6 $210 {5# beef, 2012 $9 $6 $210
25# chicken}
2012: Households bought {5 lbs beef, 25 lbs chicken}.
A. Compute cost of the 2012 household basket.
A. Compute cost of the 2012 household basket.
($9 x 5) + ($6 x 25) = $195
B. Compute % increase in cost of household basket
over 2011–12, compare to CPI inflation rate.
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ACTIVE LEARNING 2 Problems with the CPI:

Answers Introduction of New Goods
CPI basket:  The introduction of new goods increases variety,
cost of CPI
{10# beef, beef chicken allows consumers to find products that more
basket
20# chicken}
2010 $4 $4 $120 closely meet their needs.
Household
basket in 2012: 2011 $5 $5 $150  The CPI misses this effect because it uses a
{5# beef, 2012 $9 $6 $210 fixed basket of goods.
25# chicken}  Thus, the CPI overstates increases in the cost of
B. Compute % increase in cost of household basket living.
over 2011–12, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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Problems with the CPI: Contrasting the CPI and GDP Deflator
Unmeasured Quality Change
 Improvements in the quality of goods in the  GDP deflator reflects the prices of all goods and
basket increase the value of each dollar. services produced domestically, whereas the CPI
reflects the prices of all goods and services bought
 The BLS tries to account for quality changes
by consumers.
but probably misses some, as quality is hard to
measure.  CPI compares the price of a fixed basket of goods
and services to the price of the basket in the base
 Thus, the CPI overstates increases in the cost of
year. By contrast, the GDP deflator compares the
living. price of currently produced goods and services to
the price of the goods and services in the base
year.
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ACTIVE LEARNING 3 How does BBS estimate CPI?
A. Starbucks raises the price of Frappuccinos.  The National Accounting Wing of the Bangladesh
Bureau of Statistics (BBS) has been regularly
The CPI and GDP deflator both rise. constructing and disseminating CPI data for the
country.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.  Monthly prices of the different items in the basket
are collected to construct CPI on a monthly basis
The GDP deflator rises, the CPI does not. while annual indices are prepared by averaging
C. Armani raises the price of the Italian jeans it the 12 month’s values
sells in the U.S.  In calculating the indices, all the goods and
services included in the market basket are
The CPI rises, the GDP deflator does not.
classified under 8 commodity groups.
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How does BBS estimate CPI? How does BBS estimate CPI?
Procedure of data collection  Procedure of data collection
 Selection of the CPI basket items
 Selection of the CPI basket items  The indices are shown by general aggregation and separately
by food and non-food groups.
 CPI basket must be as close as possible to be  Non-food CPIs for national, urban and rural groups are further
representative of the purchases of a typical disaggregated by
(i) clothing and footwear
consumer in the country (ii) gross rent, fuel and lighting,
 BBS conducts the Household Income (iii) furniture, furnishing, household equipment and operation,
(iv) medical care and health expenses
Expenditure Survey (HIES) in every five years (v) transport and communications
and the HIES data is used for this purpose (vi) recreation, entertainment, education and cultural services and
(vii) miscellaneous goods and services.
 The national basket comprises of rural and urban
 The rural basket consists of 318 items (food 133 and non-
ones. food 185) while the urban one is made up of 422 items (food
151 and non-food 271).
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 Market  Outlets
o Data is collected from 64 urban and 64 rural  There are several outlets in the market that sell
markets various consumer items
o Price data is also collected for the Dhaka  3 are selected for price data collection
Metropolitan City from 12 selected markets  Usually the big outlets that sell a variety of
o Selected markets in the various areas are items are selected for this purpose.
typically large markets but Super markets are  The outlets are from different regional levels like
excluded urban, rural, district and divisional headquarters
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 Data Collection  Selecting the Base year
 The process requires that the price collectors  In practice, the year of HIES survey is used as
act and bargain like real buyers in the market the base year, because different types of
and make actual purchases of the selected weights used in constructing CPI come from
commodities. HIES data.
 The data is checked immediately after collection  Currently, 2005-06 is used as the base year.
to make sure that the prices of the correct Previously it was 1995-96
commodities (as specified in the CPI product
list) have been obtained
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 Determination of the weights Determination of the weights
 In the case of National CPI, all urban and rural
indices are combined using as weights the total
country wide urban and rural household
expenditure
National CPI =
(64.89 × rural CPI) + (35.11 × urban CPI)
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Correcting Variables for Inflation:

How does BBS estimate CPI? Comparing Dollar Figures from Different Times
 Inflation makes it harder to compare dollar
amounts from different times.
 Example: the minimum wage
 $1.15 in Dec 1964
 $7.25 in Dec 2010
 Did min wage have more purchasing power in
Dec 1964 or Dec 2010?
 To compare, use CPI to convert 1964 figure into
“today’s dollars”…
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Correcting Variables for Inflation: Correcting Variables for Inflation:

Comparing Dollar Figures from Different Times Comparing Dollar Figures from Different Times
Amount Amount  Researchers, business analysts, and policymakers

Price level today
in today’s = in year T x often use this technique to convert a time series of
dollars dollars Price level in year T current-dollar (nominal) figures into constant-dollar
(real) figures.
 In our example,
 “year T” is 12/1964, “today” is 12/2010  They can then see how a variable has changed
 Min wage was $1.15 in year T over time after correcting for inflation.
 CPI = 31.3 in year T, CPI = 220.3 today  Example: the minimum wage, from Jan 1960 to
Dec 2010…
The minimum wage 220.3
in 1964 was $8.09 $8.09 = $1.15 x
31.3
in today’s (2010) dollars.
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Comparing tuition increases Answers
Tuition and Fees at U.S. Colleges and Universities 1990 2010 % change
1990 2010 CPI 130.7 218.1 66.9%
Private non-profit 4-year $9,340 $27,293 Private non-profit 4-year
$9,340 $27,293
(current $)
Public 4-year $1,908 $7,605 Private non-profit 4-year
$15,586 $27,293 75.1%
(2010 $)
Public 2-year $906 $2,713
Public 4-year (current $) $1,908 $7,605
CPI 130.7 218.1
Public 4-year (2010 $) $3,184 $7,605 138.9%
Instructions: Express the 1990 tuition figures in 2010
dollars, then compute the percentage increase for all Public 2-year (current $) $906 $2,713
three types of schools. Which type experienced the
Public 2-year (2010 $) $1,512 $2,713 79.4%
largest increase?
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Correcting Variables for Inflation: Correcting Variables for Inflation:

Indexation Real vs. Nominal Interest Rates
The nominal interest rate:
A dollar amount is indexed for inflation
if it is automatically corrected for inflation  the interest rate not corrected for inflation
by law or in a contract.  growth rate in dollar value of a deposit or debt
 the rate we always hear about
For example, the increase in the CPI automatically The real interest rate:
determines  corrected for inflation
 the COLA in (NOT) many multi-year labor  growth rate in purchasing power of a deposit or
contracts debt
 adjustments in Social Security payments and  the rate we never hear about
federal income tax brackets Real interest rate = (nominal interest rate) – (inflation rate)
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Correcting Variables for Inflation:

Real vs. Nominal Interest Rates
Real vs. Nominal Income
 Real Income is defined as the income that is
Example:
obtained after taking into consideration the
 Deposit $1,000 for one year. effects of inflation. Therefore we have:
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
Real Income = Nominal Income/CPI
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5% % change in real income = % change in nominal
 The purchasing power of the $1000 deposit income – % change in CPI (inflation)
has grown 5.5%.
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Inflation Inflation
 A sustained rise in the overall level of prices in  Stagflation - a high inflation rate is combined
an economy. with a high level of unemployment and a
 Economists use various price indexes to slowdown of the economy
measure the overall price level, also called the
aggregate price level.  Deflation- A sustained decrease in aggregate
 Inflation rate is the percentage change in a price price level, which corresponds to a negative
index-that is, the speed of overall price level inflation rate—that is, an inflation rate of less
movements. than 0%.
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Inflation Inflation
 Hyperinflation- An extremely fast increase in
aggregate price level, which corresponds to an  Types of inflation
extremely high inflation rate—for example, 500% to
1000% per year.  Demand-Pull Inflation - increasing demand
raise prices generally
 Disinflation- A decline in the inflation rate, such as  Cost-Push Inflation- rising costs, usually wages,
from around 15% to 20% to 5% or 6%.
 Disinflation is very different from deflation because compel businesses to raise prices generally
even after a
period of disinflation, the inflation rate remains
positive and the aggregate price level keeps rising
(although at a slower speed).
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Inflation Inflation
 Commonly used methods in inflation calculation 3. 12 month average inflation =
1. Monthly Inflation = [(avg. CPI last 12 months – avg. CPI previous 12
12 *[ (CPIt – CPIt-1)/ CPIt-1 ]* 100 months)/ avg. CPI previous 12 months] × 100
[t = month, t-1 = previous month]

2. Point to point inflation =
[(CPIi,t – CPIi, t-1)/ CPIi,t-1 ]* 100
[i,t= i-th month of year t; i,t-1 = i-th month of year t-
1 (previous year)]
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Inflation Inflation
Other Measures of Price and Inflation Other Measures of Price and Inflation
 Core Inflation  Producers Price Index
 the steady or persistent component of inflation  looks at the changes in the price level from the
that is free from disturbances that only have perspective of the manufacturers/producers
temporary effects on price levels  measures the average change in the price of a
 In tracking inflation, policymakers want to avoid basket of representative goods and services
being misled by rapid but temporary price sold by manufacturers and producers in the
changes that may distort the inflation picture wholesale market.
 BBS does not construct the core inflation  also called the Wholesale Price Index (WPI)
 can be used to predict the CPI
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S UMMARY
• The Consumer Price Index is a measure of the

cost of living. The CPI tracks the cost of the
typical consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living Thank You!
Adjustments and to correct economic variables
for the effects of inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.
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2/13/2020

N. Gregory Mankiw In this chapter,

How the CPI Is Calculated How the CPI Is Calculated

How the CPI Is Calculated EXAMPLE basket: {4 pizzas, 10 lattes}

using 2010 base year:

ACTIVE LEARNING 1 ACTIVE LEARNING 1

CPI in 2011 = 100 x ($150/$120) = 125

ACTIVE LEARNING 1 Problems with the CPI:

ACTIVE LEARNING 2 ACTIVE LEARNING 2

ACTIVE LEARNING 2 Problems with the CPI:

ACTIVE LEARNING 3 How does BBS estimate CPI?

Correcting Variables for Inflation:

Correcting Variables for Inflation: Correcting Variables for Inflation:

Amount Amount  Researchers, business analysts, and policymakers

ACTIVE LEARNING 4 ACTIVE LEARNING 4

Correcting Variables for Inflation: Correcting Variables for Inflation:

Correcting Variables for Inflation:

[t = month, t-1 = previous month]

• The Consumer Price Index is a measure of the

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