CH 24

N.
GREGORY MANKIW NINTH EDITION
PRINCIPLES OF
ECONOMICS
CHAPTER
Measuring the
24 Cost of Living
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The Cost of Living
• We need all sorts of things to live
• These things are typically not free
• How are we to measure the cost of living
the way we actually live?
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 2
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
The Cost of Living
• Q: Why do we need to know the
cost of living?
• A: To see whether our incomes
are keeping up with the cost of
living
The Cost of Living
• In Ch. 23 we saw that the GDP Deflator
gives us one number that represents the
overall level of the prices of all domestically-
produced final goods and services
• But not all final goods are bought by
consumers
• We now need one number that represents
the overall level of the prices of all goods
that a typical consumer buys
• This is the Consumer Price Index
IN THIS CHAPTER
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI? How
serious are they?
• 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
want to do this, anyway?
• How can we correct interest rates for inflation?
5
The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall cost of goods and services
bought by a typical consumer
– Measure the typical consumer’s cost of living; is the
basis of cost of living adjustments (COLAs) in many
contracts and in Social Security.
– 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.
– The Bureau of Labor Statistics (BLS) reports the U.S.
CPI each month:
• https://www.bls.gov/news.release/cpi.toc.htm
-
6
CHAPTER 6 MEASURING THE COST OF LIVING 7
The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall cost of goods and
services bought by a typical consumer
– Monitor changes in the cost of living over time
• Core CPI
– A measure of the overall cost of consumer
goods and services excluding food and energy
• Producer price index (PPI)
– A measure of the cost of a basket of goods and
services bought by firms
• http://research.stlouisfed.org/fred2/series/CPIAU
CSL
CHAPTER 6 MEASURING THE COST OF LIVING
9
How the CPI Is Calculated – 1
1. Fix the basket
– The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices
– The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost
– Use the prices to compute the total cost of the
basket.
How the CPI Is Calculated – 2
4. Chose a base year and compute the CPI
• Designate a year as base year (benchmark)
CPI = [Basket’s cost in current year / Basket’s
cost in base year] × 100
5. Compute the inflation rate
• Percentage change in the CPI from the
preceding period
CPI this year−CPI last year
In#lation rate = ×100
CPI last year
12
How the Consumer Price Index Is Calculated
• Fix the basket: determine what “basket”

of goods the typical consumer buys.
– The Bureau of Labor Statistics (BLS)
identifies a market basket of goods and
services the typical consumer buys.
– The BLS conducts monthly consumer
surveys to set the weights for the prices of
those goods and services.

The typical basket of goods and services
13
Understanding the CPI
Example with 3 goods
For good i = 1, 2, 3
Ci = the amount of good i in the CPI’s basket
Pit = the price of good i in month t

Et = the cost of the CPI basket in month t
Eb = the cost of the basket in the base period
Understanding the CPI
Et P1tC1 + P2t C2 + P3t C3

CPI in month t = =
Eb Eb
æ C1 ö æ C2 ö æ C3 ö
= ç ÷ P1t + ç ÷ P2t + ç ÷ P3t
è Eb ø è Eb ø è Eb ø
The CPI is a weighted average of prices.
The weight on each price reflects
that good’s relative importance in the CPI’s basket.
Note that the weights remain fixed over time.
16
• Find the Prices: Find the prices of each

of the goods and services in the typical
consumer’s basket at each point in time.
– These prices are the prices paid by the
typical consumer

17
• Compute the Basket’s Cost: Use the

data on prices to calculate the cost of the
typical consumer’s basket in different
years.

18
• Choose a Base Year and Compute the

CPI:
– Designate
• Compute a particular
the inflation rate: Theyear as rate
inflation the for
base year,
a given year
is the percentage
making it theincrease in the CPI
benchmark from thewhich
against preceding
other
period.
years are compared.
– Compute the CPI forCPIaingiven
Year 2 - year as 1follows:
CPI in Year
Inflation Rate in Year 2 = ´100
• divide the cost of the typical consumer’s
CPI in Year 1 basket in the
given year by its cost in the base year
• multiply the result by 100

19
• http://research.stlouisfed.org/fred2/series/CPIAUCSL
20
Video： Measuring Inflation
• Inflation video.mp4

EXAMPLE 1: Market basket: 10 pizzas, 5 shirts
Price of Price of
year Cost of basket
pizza shirts
2017 $12 $18 $12 × 10 + $18 × 5 = $210
2018 $14 $20 $14 × 10 + $20 × 5 = $240
2019 $16 $22 $16 × 10 + $22 × 5 = $270
Compute CPI in each year (2017 base year)
In#lation rate
2017: 100 x ($210/$210) = 100 114.3 − 100
14.3% = ×100
100
2018: 100 x ($240/$210) = 114.3 128.6 − 114.3
12.5% = ×100
2019: 100 x ($270/$210) = 128.6 114.3
22
Active Learning 1: Calculate CPI & inflation rate
CPI basket: Price of Price of
year
10 lbs of beef, beef chicken
2017 $3 $3
20 lbs of chicken
2018 $4 $4
Base year: 2017 2019 $8 $5
A. Calculate CPI for all years

B. What was the inflation rate from 2018-
2019?
23
Active Learning 1: Answers (10 beef, 20 chicken)
Price of Price of
year Cost of basket
beef chicken
2017 $3 $3 $3×10+$3×20 = $90
2018 $4 $4 $4×10+$4×20 = $120
2019 $8 $5 $8×10+$5×20 = $180
year A. Consumer price index B. Inflation rate 2018-2019

2017 100×(90/90) = 100
2018 100×(120/90) = 133.3 200 − 133.3
×100 = 50%
2019 100×(180/90) = 200 133.3
24
Active Learning 2: A new basket, CPI & inflation rate
New CPI basket for 2019: Price of Price of

year
5 lbs of beef, beef chicken
2017 $3 $3
25 lbs of chicken
2018 $4 $4
Base year: 2017 2019 $8 $5
A. Calculate cost of the new basket for 2019

and the CPI for 2019.
B. What’s the new inflation rate from 2018-
2019?
25
Active Learning 2: Answers
Price of Price of
year
beef chicken
A. Cost of basket
2017 $3 $3 $90
2018 $4 $4 $120
2019 $8 $5 $8×5+$5×25 = $165
year A. Consumer price index B. Inflation rate 2018-2019

2017 100
2018 133.3 183.3 − 133.3
×100 = 37.5%
2019 100×(165/90) = 183.3 133.3
26
27
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.

28

• Substitution bias
• Introduction of new goods
• Unmeasured quality changes

Problems with the CPI – 1
• Substitution Bias
– Over time, some prices rise faster than others
– 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. It does not change to
reflect consumer reaction to changes in relative
prices.
– Thus, the CPI overstates increases in the cost of
living by not considering consumer substitution.
30
Substitution Bias in CPI

• Suppose Red Apples and Green Apples are the only two
commodities and are identical except for color.
• Suppose the typical consumer’s basket has, for many
years, contained 10 of each type.
• Suppose the prices in 2015 (the base year) were $2 per
apple for both types. So, the cost of the consumer’s basket
was $40 in 2015.
• Suppose the prices in 2016 are $4 for a Red Apple and $2
for a Green Apple. So, the cost of the consumer’s basket is
$60 in 2016.
• Therefore, the CPI for 2016 is (60/40) × 100 = 150,
indicating a 50% increase in the cost of living
• But has the cost of living really increased?
• No. The consumer can switch to zero Red Apples and 20
Green Apples and enjoy the same satisfaction as always
without any increase in cost.
• Therefore, the CPI exaggerates the true cost of living.
• Introduction of New Goods
– The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
– In effect, dollars become more valuable.
– The CPI misses this effect because it uses a
fixed basket of goods. It does not reflect the
change in purchasing power brought on by the
introduction of new products.
– Thus, the CPI overstates increases in the cost of
living.
• Unmeasured Quality Change
– Improvements in the quality of goods in the basket
increase the value of each dollar.
– 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 account for quality changes but
probably misses some, as quality is hard to measure.
– Thus, the CPI overstates increases in the cost of living.
33

• 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.
Two measures of inflation, 1965–2019
34
35
The GDP Deflator Versus the Consumer Price Index
• Economists and policymakers monitor both

the GDP deflator and the consumer price
index to gauge how quickly prices are rising.
• There are, however, two important
differences between the indexes

36
• We discussed the GDP deflator in Chapter

23 (Measuring a Nation’s Income)
• The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator = ´ 100
Real GDP

Market value of all
final goods and
services produced in
GDP Deflator 2017 at 2017 prices
for 2017 with = × 100
base year 2009 Market value of all
final goods and
2017 at 2009 prices
$600
= × 100
$200
= 300
Market value of all
final goods and
for 2017 with = × 100
Why are the goods
final goods and
produced in 2017 worth services produced in
3 times as much at
2017 prices as at 2009 2017 at 2009 prices
prices?
It must be that 2017
prices are, on average,
3 times as high as 2009 $600
prices. = × 100
This is what the GDP $200
Deflator is saying. = 300
Market value of all
final goods and
for 2017 with = × 100
The GDP Deflator is
final goods and
300. This indicates that services produced in
the 2017 prices of
domestically produced 2017 at 2009 prices
final goods and services
were on average 300
percent of the $600
corresponding prices in = × 100
2009, the base year. $200
= 300
GDP Deflator CPI
Market value of all final goods Market value of the typical

and services produced in 2017 consumer’s basket at 2017
GDP Deflator at 2017 prices CPI for 2017 prices
for 2017 with = × with base year = ×
base year 2009 Market value of all final goods 100 2009 Market value of the typical 100
at 2009 prices prices


41
• The GDP deflator reflects the prices of all

final goods and services produced
domestically, whereas...
• …the consumer price index reflects the
prices of all final goods and services bought
by consumers.

42
• The Consumer Price Index compares the

price of a fixed basket of goods and
services to the price of the basket in the
base year (only occasionally does the BLS
change the basket)...
• …whereas the GDP deflator compares the
price of currently produced goods and
services to the price of the same goods and
services in the base year.

GDP Deflator vs. CPI
• Imported consumer goods:
– Included in CPI but excluded from GDP deflator
• Capital goods:
– Excluded from CPI but included in GDP deflator
(if produced domestically)
• The basket:
– CPI: fixed basket; prices of all goods and
services bought by consumers
– GDP deflator: prices of all goods and services
currently produced domestically
Active Learning 3: CPI vs. GDP deflator
In each scenario, determine the effects on
the CPI and the GDP deflator.
A. Starbucks raises the price of muffins.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois
factory.
C. Armani raises the price of the Italian jeans
it sells in the U.S.
44
A. Starbucks raises the price of muffins.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it

sells in the U.S.
The CPI rises, the GDP deflator does not.
45
46
Correcting Economic Variables For The Effects Of Inflation
• The Consumer Price Index is used to

correct for the effects of inflation when
comparing dollar figures from different eras.
– See the BLS’s inflation calculator
• Researchers, business analysts, and
policymakers often use this technique to
convert a time series of current-dollar
(nominal) figures into constant-dollar (real)
figures. They can then see how a variable
has changed over time after correcting for
inflation.

Dollar Figures From Different Times
• Comparing dollar figures from different
times:
– Inflation makes it harder to compare dollar
amounts from different times.
Amount in today′s dollars =

Price level today
= Amount in year T dollars×
Price level in year T
EXAMPLE 2: Great-grandpa’s salary
Your great grandpa’s first full time job was as
a car mechanic in 1963, and he was earning
$310/month.
CPI in 1963: 30.9
CPI in 2019: 256.6
• How much great grandpa’s earnings are in
current dollars?
• Amount in today’s (2019) dollars =

$310×256.6/30.9 = $2,574.30
48
Active Learning 4: Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2018
Private non-profit 4-year $9,340 $35,830
Public 4-year $1,908 $10,230
Public 2-year $906 $3,660

CPI 130.7 251.1
A. Express the 1990 tuition figures in 2018 dollars, then
compute the percentage increase in real terms for all
three types of schools.
B. Which type experienced the largest increase in real
tuition costs?
49
1990 2018 % change
CPI 130.7 251.1 92.1%
Private non-profit 4-year
$9,340 $35,830
(current $)
Private non-profit 4-year
$17,944 $35,830 99.7%
(in 2018 $)
Public 4-year (current $) $1,908 $10,230
Public 4-year (in 2018 $) $3,665 $10,230 179.1%
Public 2-year (current $) $906 $3,660
Public 2-year (in 2018 $) $1,741 $3,660 110.3%
50
Indexation
• Indexation
– A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
• The increase in CPI automatically
determines:
– The COLA in many multi-year labor
contracts.
– Adjustments in Social Security payments and
federal income tax brackets.
Real and Nominal Interest Rates
• The concept of an interest rate involves
comparing amounts of money at different
points in time.
• The future dollars could have a different
value than today’s dollars.
• It is important to correct the interest rates
for the effects of inflation.
Real and Nominal Interest Rates
• The nominal interest rate:
– Measures the change in dollar amounts
– Interest rate not corrected for inflation
– Rate of growth in the dollar value of a deposit or debt
• The real interest rate:
– Corrected for inflation
– Rate of growth in the purchasing power of a deposit or
debt
– Tells you how fast the purchasing power of your bank
account rises over time
Real interest rate = (nominal interest rate) – (inflation rate)
Example 3: Real vs. nominal interest rates
Amir received a $1,000 end-of-year bonus at his
job. He deposits the $1,000 in his savings
account for one year. The nominal interest rate is
9%. During that year, inflation is 3.5%.
• At the end of the year, is Amir able to buy more
or fewer goods with his money? How much?
• Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
• The purchasing power of the $1,000 deposit
has grown by 5.5%.
54
Real & nominal interest rates, the U.S., 1965–2019
Nominal interest rate

Real interest rate
Interest rate (percent per year)
55
THINK-PAIR-SHARE
Your grandfather quit smoking cigarettes
in 1995. When you ask him why he quit, you
get a surprising answer. Instead of reciting
the health benefits of quitting smoking, he
says, “I quit because it was just getting too
expensive. I started smoking in 1965 in
Vietnam and cigarettes were only 45 cents a
pack. The last pack I bought was $2.00 and I
just couldn’t justify spending more than four
times as much on cigarettes as I used to.”
56
THINK-PAIR-SHARE
A. In 1965, the CPI was 31.5. In 1995, the CPI was
152.4. While it is commendable that your
grandfather quit smoking, what is wrong with his
explanation?
B. What is the equivalent cost of a 1965 pack of
cigarettes measured in 1995 prices?
C. What is the equivalent cost of a 1995 pack of
cigarettes measured in 1965 prices?
D. Do both methods give you the same conclusion?
57
CHAPTER IN A NUTSHELL
• The consumer price index (CPI) shows the
cost of a basket of goods and services
relative to the cost of the same basket in the
base year.
• Used to measure the overall level of prices in
the economy.
• The percentage change in the CPI measures
the inflation rate.
58
• The CPI overstates true inflation:
• It does not take into account consumers’ ability
to substitute toward goods that become
relatively cheaper over time
• It does not take into account increases in the
purchasing power of the dollar that result from
the introduction of new goods.
• It is distorted by unmeasured changes in the
quality of goods and services
59
• Like the CPI, the GDP deflator measures the
overall level of prices in the economy.
• The two price indexes usually move together
• The GDP deflator differs from the CPI because it
reflects the prices of goods and services
produced domestically rather than of goods and
services bought by consumers.
• While the CPI uses a fixed basket of goods, the
group of goods and services reflected in the
GDP deflator automatically changes over time
as the composition of GDP changes.
60
• To compare a dollar figure from the past with
a dollar figure today, the older figure should
be inflated using a price index.
• Various laws and private contracts use price
indexes to correct for the effects of inflation.
Tax laws, however, are only partially
indexed for inflation.
61
• Correcting for inflation is especially
important when looking at data on interest
rates.
• The nominal interest rate is the rate at which the
number of dollars in a savings account
increases over time.
• The real interest rate is the rate at which the
purchasing power of a savings account
increases over time. It equals the nominal
interest rate minus the rate of inflation.
62
Homework
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N.

GREGORY MANKIW NINTH EDITION

How the Consumer Price Index Is Calculated

• Fix the basket: determine what “basket”

CHAPTER 6 MEASURING THE COST OF LIVING

Example with 3 goods

Ci = the amount of good i in the CPI’s basket

Pit = the price of good i in month t

Et P1tC1 + P2t C2 + P3t C3

How the Consumer Price Index Is Calculated

• Find the Prices: Find the prices of each

CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated

• Compute the Basket’s Cost: Use the

CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated

• Choose a Base Year and Compute the

CHAPTER 6 MEASURING THE COST OF LIVING 14

CHAPTER 6 MEASURING THE COST OF LIVING

CHAPTER 6 MEASURING THE COST OF LIVING

CHAPTER 6 MEASURING THE COST OF LIVING 21

A. Calculate CPI for all years

year A. Consumer price index B. Inflation rate 2018-2019

New CPI basket for 2019: Price of Price of

A. Calculate cost of the new basket for 2019

year A. Consumer price index B. Inflation rate 2018-2019

Problems in Measuring the Cost of Living

CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living

CHAPTER 6 MEASURING THE COST OF LIVING

Substitution Bias in CPI

Problems in Measuring the Cost of Living

The GDP Deflator Versus the Consumer Price Index

• Economists and policymakers monitor both

CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index

• We discussed the GDP deflator in Chapter

CHAPTER 6 MEASURING THE COST OF LIVING

Market value of all final goods Market value of the typical

Market value of all final goods Market value of the typical

Market value of all final goods Market value of the typical

The GDP Deflator Versus the Consumer Price Index

• The GDP deflator reflects the prices of all

CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index

• The Consumer Price Index compares the

CHAPTER 6 MEASURING THE COST OF LIVING

B. Caterpillar raises the price of the industrial

C. Armani raises the price of the Italian jeans it

Correcting Economic Variables For The Effects Of Inflation

• The Consumer Price Index is used to

CHAPTER 6 MEASURING THE COST OF LIVING

Amount in today′s dollars =

• Amount in today’s (2019) dollars =

Public 4-year $1,908 $10,230

Public 2-year $906 $3,660

Public 4-year (in 2018 $) $3,665 $10,230 179.1%

Public 2-year (current $) $906 $3,660

Public 2-year (in 2018 $) $1,741 $3,660 110.3%

Nominal interest rate

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