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Course Code and Title : ACED1 – ECONOMIC DEVELOPMENT

Lesson Number : 5
Topic : Measuring the Cost of Living
Professor : Lucia Wong Lazo

INTRODUCTION:

The consumer price index (CPI) is a measure

of the overall cost of the goods and services bought
by a typical consumer. The Bureau of Labor Statistics
reports the CPI each month. 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.

LEARNING OBJECTIVES:
At the end of the lesson, you should be able to:
1. Evaluate, analyze and calculate the Consumer Price Index (CPI);
2. Measure and compare Consumer Price Index (CPI) to Gross Domestic Product (GDP);
3. Support the use of price index with dollar figures at different times.

PRE-ASSESSMENT:
On a sheet of paper, please answer the following:
1. How do we measure the cost of living?
2. What is the relationship between cost of living and standard of living?

LESSON:
What is Consumer Price Index (CPI)?

The Consumer Price Index (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
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averaging them. Changes in the CPI are used to assess price changes associated with the cost of
living. The CPI is one of the most frequently used statistics for identifying periods of  inflation or
deflation. Video link: https://www.investopedia.com/terms/c/consumerpriceindex.asp Consumer
Price Index Source: Investopedia.com.

Understanding Consumer Price Index (CPI)

The CPI measures the average change in prices over time that consumers pay for a basket
of goods and services, commonly known as inflation. Essentially it attempts to quantify the
aggregate price level in an economy and thus measure the purchasing power of a country's unit of
currency. The weighted average of the prices of goods and services that approximates an
individual's consumption patterns is used to calculate CPI. A trimmed mean may be used as part of
this. Video Link: https://study.com/academy/lesson/consumer-price-index-measuring-the-cost-of-
living-and-inflation.html

How is CPI Used?

CPI is an economic indicator. It is the most widely used measure of inflation and, by
proxy, of the effectiveness of the government’s economic policy. The CPI gives the government,
businesses, and citizens an idea about prices changes in the economy, and can act as a guide in
order to make informed decisions about the economy. 
The CPI and the components that make it up can also be used as a deflator for other
economic indicators, including retail sales, hourly/weekly earnings. Additionally, it can be used to
value a consumer’s dollar to find its purchasing power. Generally, the dollar’s purchasing power
declines when the aggregate price level increases and vice versa. 

The index can also be used to adjust people’s eligibility levels for certain types of
government assistance including Social Security and it automatically provides the cost-of-living
wage adjustments to domestic workers. According to the BLS, the cost-of-living adjustments of
more than 50 million people on Social Security, as well as military and Federal Civil Services
retirees are linked to the CPI.
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Who and What Are Covered?

The CPI statistics cover professionals, self-employed, poor, unemployed and retired people
in the country. People not included in the report are non-metro or rural populations, farm families,
armed forces, people serving in prison and those in mental hospitals.

The CPI represents the cost of a basket of goods and

services across the country on a monthly basis. Those
goods and services are broken into eight major groups

Calculating Consumer Price Index

The formula used to calculate the Consumer Price Index for

a single item is as follows:

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

Problems in Measuring the Cost of Living

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.

1. Substitution bias The basket does not change to reflect consumer reaction to changes in
relative prices. Consumers substitute toward goods that have become relatively less expensive. The
index overstates the increase in cost of living by not considering consumer substitution.

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. Consumers need fewer dollars to maintain any given standard of
living.
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3. Unmeasured quality changes 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. The
BLS tries to adjust the price for constant quality, but such differences are hard to measure. The
substitution bias, introduction of new 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.

Real vs. Nominal Interest Rates

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.

A real interest rate is the interest rate that takes inflation into account. This means it adjusts
for inflation and gives the real rate of a bond or loan. To calculate the real interest rate, you first
need the nominal interest rate. The calculation used to find the real interest rate is the nominal
interest rate minus the actual or expected inflation rate. 

Real interest rates should be considered predictive when the true rate of inflation is unknown
or expected.

Example:
Suppose a bank loans a person $200,000 to purchase a house at a rate of 3%—
the nominal interest rate not factoring in inflation. Assume the inflation rate is 2%. The
real interest rate the borrower is paying is 1%. The real interest rate the bank is receiving
is 1%. That means the purchasing power of the bank only increases by 1%.

The real interest rate gives lenders and investors an idea of the real rate they receive after
factoring in inflation. This also gives them a better idea of the rate at which their purchasing
power increases or decreases. They can estimate their real rate of return by comparing the
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difference between a Treasury bond yield and a Treasury Inflation-Protected Securities (TIPS) yield

of the same maturity, which estimates inflation expectations in the economy.

Nominal Interest Rates

A nominal interest rate refers to the interest rate before taking inflation into account. It is the
interest rate quoted on bonds and loans. The nominal interest rate is a simple concept to
understand. If you borrow $100 at a 6% interest rate, you can expect to pay $6 in interest without
taking inflation into account. The disadvantage of using the nominal interest rate is that it does not
adjust for the inflation rate.

Short-term nominal interest rates are set by central banks. These rates are the basis for other
interest rates that are charged by banks and other institutions to consumers. Central banks may
decide to keep nominal rates at low levels in order to spur economic activity. Low nominal rates
encourage consumers to take on more debt and increase their spending.

GENERALIZATION:

The consumer price index (CPI) is the most widely used measure of the level of prices. It is
constructed by collecting the prices of thousands of goods and services.

We know that the GDP expresses the quantity of diverse goods and services into a single
number which is used as a measure of the value of society’s output. In a like manner the CPI
expresses the prices of numerous goods and services into a single index for measuring the general
price level.

The CPI is a weighted average of all prices. It is the price of a basket of goods and services
relative to the price of the same basket in some base year.

Since market basket of goods and services remains fixed over time, the CPI tends to
overestimate inflation. The main reason is that when the prices of some goods rise sharply,
consumers have a tendency to switch their purchases to goods whose prices have not risen as
much or not at all. But the CPI ignores the rise completely. This is known as substitution bias. The
CPI does not reflect changing consumption.
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It is also possible to prepare price indices at the micro-level, i.e., for specific types of goods
such as food, housing and energy. Different indices are used for different purposes.

EVALUATION:

On a sheet of paper, analyze and answer the following:

1. Below is a list of annual CPI values for the years 2000-2003. Using these values,
calculate the average annual rate of inflation over this period.
Year CPI

2000 200.2

2001 205.6

2002 208.2

2002 209.1
2. Below is a list of annual CPI values for the fictional country of Zeuslandia. During
which year did this country experience the lowest annual inflation rate? Explain.

Year CPI
1985 100
1986 105
1987 110

1988 115

REINFORCEMENT:

Research work on the topic “Production and Growth” details as follows:

1. How much economic growth differs around the world?

2. Why productivity is the key determinant of a country’s standard of living?
3. What are the factors that determine a country’s productivity?
4. How a country’s policy determines its productivity growth?
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REFERENCES:

Video link: https://www.investopedia.com/terms/c/consumerpriceindex.asp Source:

Investopedia.com
http://www.ukm.my/hairun/Ecn3100/measuring%20the%20cost%20of
%20living.pdf
https://www.economicsdiscussion.net/measurements/measurement-of-cost-of-living-3-
measurements/15368