© 2007 Thomson South-Western

Measuring the Cost of Living

 Inflation refers to a situation in which the economy’s price
level is rising – like a Tax.

 The inflation rate is the rate of change in the price level

from the previous period (month or year).

 Causes of Inflation: Demand-Pull, Cost-Push

 Consequences:
 (a) reduces value of money/purchasing power; (b)
increases employment in the short-run; © decreases GDP
in the long-run ; (d) uncertainty in resouce allocation; (e)
reduces exports and increases imports.
2
THE CONSUMER PRICE INDEX
 The consumer price index (CPI) is a
measure of the overall cost of the goods
and services bought by a typical
consumer. CPI is one way of measuring
the price level.
 It is used to monitor changes in the cost
of living over time.

3
THE CONSUMER PRICE INDEX
When the CPI increases, the average family has to spend
more money to maintain the same standard of living.

4
How the CPI Is Calculated
1. Fix the basket. Determine the quantity of
each good that the average consumer
buys.
 Identify a basket of goods and services the
typical consumer buys.
 Conduct monthly consumer surveys to
determine the quantities of those goods and
services.

5
How the CPI Is Calculated
2. Find the prices. Find the prices of each of
the goods and services in the basket for
each period (month or year).
3. Calculate the cost of the basket. Use the
data on prices to calculate the cost of the
basket of goods and services at each
period.

6
How the CPI Is Calculated
4. Choose a base year and compute the
index.
 Choose one year as the base year, so that we
can compare across years more clearly.
 Compute the index by dividing the cost of the
basket in one year by the cost of the basket in
the base year and multiplying by 100.

Current Cost of the basket

CPI  100
Base Year Cost of basket

7
How the CPI Is Calculated
5. Calculate the inflation rate. The inflation
rate is the rate of change in the consumer
price index between years (or months).

8
How the CPI Is Calculated

 The inflation rate is calculated as follows:

CPI in Year 2  CPI in Year 1

Inflation Rate in Year 2= 100
CPI in Year 1

9
Table 1: Calculating the Consumer Price
Index and the Inflation Rate: An Example

10
Table 1: Calculating the Consumer Price
Index and the Inflation Rate: An Example

11
How the CPI Is Calculated
 Calculating the Consumer Price Index and
the Inflation Rate: Another Example
 Base Year is 2002.
 Basket of goods in 2002 costs 1,200 YTL.
 The same basket in 2004 costs 1,236 YTL.
 CPI = (1,236/1,200)  100 = 103.
 Prices increased by 3 percent between 2002
and 2004. (Remember that base year CPI is
always 100)

12
What Is in the CPI’s Basket? (US data)

17%
Transportation

15%
Food and 42%
beverages Housing

Education and
6%
communication 6%
6% 4% 4%

Medical care
Other goods
Recreation Apparel and services 13
CPI in Turkey CPIinflation

140

130

120

110

100

90

80

70 CPIinflation

60

50

40

30

20

10

-8
9 90 -9
1
-9
2 93 94 -9
5
-9
6
-9
7 98 99 00 -0
1 02 03 -0
4
-0
5
a n n- n n n- n- n n n n- n- n- an n- n- n an
J Ja Ja J a Ja Ja Ja Ja Ja Ja Ja Ja J Ja Ja Ja J 14
months
Problems in Measuring the Cost of Living
 The CPI is a good but not a perfect
measure of the cost of living because it
fixes the basket. Problems include:
 Substitution bias (overestimates inflation)
 Introduction of new goods
 Unmeasured quality changes

15
Problems in Measuring the Cost of Living
 Substitution Bias
 The basket does not change to reflect
consumer’s reaction to changes in relative
prices.
 Consumers substitute away from goods that have
become relatively more expensive toward goods that
have become cheaper. Think about benzene
(gasoline) and LPG.
 But CPI ignores this consumer reaction. Therefore
the index overestimates the actual inflation rate by
not considering the substitution effect.

16
Problems in Measuring the Cost of Living
 Introduction of New Goods
 The basket does not reflect the change in
purchasing power brought on by the
introduction of new products. Think about a
new Nokia cell phone coming to Turkey in
March. Increases standard of living. But the
CPI basket is fixed, ignores new products.
 New products result in greater variety, which
in turn makes each YTL more valuable.
 Consumers need fewer liras to maintain the
same standard of living.
17
Problems in Measuring the Cost of Living
 Unmeasured Quality Changes
 If the quality of the same good rises from one
year to the next, and its price does not
change, the value of one YTL rises, Ex1:
Airbags became standard in cars, but assume
that price of a car did not increase much. Ex2:
Cell phones developed a lot in last 10 years
but prices did not increase as much.
 TURKSTAT tries to adjust the price for constant
quality, but it is hard to measure quality.

18
Problems in Measuring the Cost of Living
 The substitution bias, introduction of new
goods, and unmeasured quality changes
cause the CPI to overestimate 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. (indexing)
 The CPI overestimates inflation by about 1
percentage point per year.
19
Other Indices:
 Indices for different regions within the
country, such as Istanbul, Ankara, etc.
 For various categories of goods such as
food, energy, housing etc.
 The producer price index (PPI), which
measures the cost of a basket of goods and
services bought by firms rather than
consumers. PPI is used for predicting future
CPI inflation.
 Wholesale Price Index (WPI)
20
The GDP Deflator versus the CPI

 The GDP deflator is calculated as follows:

N o m in a l G D P
G D P d e fla to r = 100
R eal G D P

21
The GDP Deflator versus the CPI
 Economists and policymakers monitor both
the GDP deflator and CPI to measure how
quickly prices are rising.
 There are two important differences
between GDP deflator and CPI.

22
The GDP Deflator versus the CPI
 GDP deflator measures the prices of all
goods and services produced in this
country, whereas...
 …the CPI reflects the prices of all goods
and services purchased by the average
consumer. So CPI includes prices of
imported goods, such as oil, natural gas,
imported cars, etc. (deflator does not)
 Does CPI include prices of military
equipment produced by Aselsan in Turkey?
Does GDP Deflator include it?
23
TL Figures from Different Times
 Let us convert Adrian Ilie’s transfer payment to
Beşiktaş, 234 000 liras in January 2004 into
liras of January 2008:

CPI in 01 / 2008
Payment01/ 2008  Payment01/ 2004 
CPI in 01 / 2004
146.94
 234,000 YTL 
104.81
 328,060 YTL

24
Indexation
 When some TL amount is automatically
corrected for inflation by law or contract,
the amount is said to be indexed for
inflation.

25
Table 2 The Most Popular Movies of
All Times, Adjusted for Inflation

26
Real and Nominal Interest Rates
 Interest rate is the cost of borrowing
money (credit) for a specified period of
time. It is the cost of renting money for a
month or year.

27
Real and Nominal Interest Rates
 The nominal interest rate is the interest
rate usually quoted in the banking system
and not corrected for inflation.
 It is the interest rate that a bank pays. Ex:
Suppose the bank pays 15% annual interest
rate on 100 YTL you deposit now. Then you will
receive 100 YTL as principal + 15 YTL as
interest payment one year from now. Are you
15% richer in terms of goods & services you
can buy? No. Because there is inflation.

28
Real and Nominal Interest Rates
 The real interest rate is the interest rate
that is corrected for the effects of inflation.
It measures real return on your deposit.
 You deposited 100 YTL for one year.
 Annual nominal interest rate is 15%.
 Suppose during the next year, people
expect that inflation will be 8%.

29
 Real and Nominal Interest Rates
 Then Fisher Equation says that:

Real Interest Rate  Nominal Interest Rate – Expected Inflation

 Real Interest Rate = 15% – 8%
= 7%
 You will receive 115 YTL next year, but
this will buy only 107 liras worth of goods
& services. You are 7% richer in real
terms. You will have 7% more purchasing
power.
30
Unexpected Inflation
 If actual inflation turns out to be greater
than expected inflation, then lenders
(depositors) lose and borrowers gain.
 If actual inflation becomes 15% instead of
8%, then your real return on your deposit
becomes 0%, not 7%. You (lender) lose
and bank (borrower) gains.

31
Summary
 The consumer price index shows the cost
of a basket of goods and services relative
to the cost of the same basket in the base
year.
 CPI is used to measure the price level in
the economy.
 The percentage change in the CPI
measures the inflation rate.

32
Summary
 The GDP deflator differs from the CPI
because deflator considers goods and
services produced but CPI considers goods
and services consumed.
 In addition, the CPI uses a fixed basket of
goods, while the GDP deflator
automatically changes the group of goods
and services over time as the composition
of GDP changes.

33
Summary
 Lira figures from different points in time
do not represent a correct comparison of
purchasing power.
 Fisher equation says that the real interest
rate equals the nominal interest rate
minus the rate of inflation.

34