Chapter 2 - Measuring the Cost of Living

The Consumer Price Index

- (CPI) : a measure of the overall cost of the goods and services bought by a
typical consumer
Calculating CPI
1-) Fix the Basket: Determine the most important prices for the typical consumer,
which involves surveying consumers to identify a basket of commonly purchased
goods and services.
2-) Find the Prices: Collect data on the prices of these items over time.
3-) Compute the Basket's Cost: Calculate the total cost of purchasing the basket
at different times to measure price changes.
4-) Choose a Base Year and Compute the Index: Select a base year for
comparison and calculate the CPI by dividing the cost of the basket in the current
year by the cost in the base year, then multiply by 100.
- CPI= Price of the basket of goods and services in the current year / Price
of basket in base year * 100
5-) Compute the Inflation Rate: Determine the percentage change in the CPI
from the previous period to measure inflation
- Inflation rate in year 2= CPI in year 2 - CPI in year 1 / CPI in year 1 * 100
Inflation Rate: The percentage change in the price index from the preceding
period.
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.

The Components of CPI

- Housing, Transportation, Food and Beverages, Medical Care, Education and
Communication, Recreation, Apparel, Other Goods and Services
 The CPI faces several challenges, such as:
- Substitution Bias: Consumers may change their buying habits as prices
change, which the CPI might not fully capture.

- Introduction of New Goods: New products increase consumers' choices and

welfare, which the CPI may not adequately reflect.

- Unmeasured Quality Changes: Quality improvements in goods and services

can also distort the CPI measurement.
The GDP Deflator versus the Consumer Price Index

GDP Deflator: Measures the price of all domestically produced goods and
services, reflecting the prices included in GDP.

CPI Differences: The CPI includes imported goods and focuses solely on
consumer purchases, potentially differing from the GDP deflator during price
changes in imports or domestic goods not consumed by households.
1. The CPI measures approximately the same economic phenomenon as ………. .

a. nominal GDP. b. real GDP. c. the GDP deflator. d. the unemployment rate.

2. The largest component in the basket of goods and services used to compute the CPI is …………… .

a. food and beverages. b. housing. c. medical care. d. apparel.

3. If a Pennsylvania gun manufacturer raises the price of rifles it sells to the U.S. Army, its price hikes
will increase

a. both the CPI and the GDP deflator. b. neither the CPI nor the GDP deflator.

c. the CPI but not the GDP deflator. d. the GDP deflator but not the CPI.

4. Because consumers can sometimes substitute cheaper goods for those that have risen in price,

a. the CPI overstates inflation. b. the CPI understates inflation.

c. the GDP deflator overstates inflation. d. the GDP deflator understates inflation.

The Usages of CPI

Purpose of Price Measurement: To enable comparison of dollar values from
different periods by accounting for inflation.

Amount in today’s dollars = (Amount in year T dollars) × CPI current / CPI past
- 251 / 15,2 × 80,000 = 1,321,052,631576 = 1,321,053

- 251 / 15,2 × 75,000 = 1,238,486,8421025 = 1,238,487

Real vs Nominal Interest Rates
Nominal Interest Rate: The nominal interest rate describes the growth rate of
the dollar amount.
Real Interest Rate: Indicates the growth rate of purchasing power over time.
Indexation: The automatic correction by law or contract of a dollar amount for
the effects of inflation

Real interest rate = Nominal interest rate - Inflation rate.

5. If the CPI is 200 for the year 1980 and 300 today, then $600 in 1980 has the
same purchasing power as .................... has today.
- $600 * (300 / 200) = $900
6. The main reason the cost of living varies across regions of the country is
differences in the price of ..............
a. food. b. clothing. c. housing. d. medical care.
7. You deposit $2,000 in a savings account, and a year later you have $2,100.
Meanwhile, the CPI rises from 200 to 204. In this case, the nominal interest
rate is.................... percent, and the real interest rate is ...........................
percent.
Nominal Interest Rate = (Ending Value−Beginning Value / Beginning Value )×100

= (2100−2000 / 2000) × 100 = 5%

Inflation Rate = ( CPIcurrent − CPIpast / CPIpast ) × 100

= ( 204−200 / 200) × 100 = 2%

Real Interest Rate = Nominal Interest Rate−Inflation Rate
= 5% − 2% = 3%
Questions For review
1. Which do you think has a greater effect on the CPI: a 10 percent increase in the price
of chicken or a 10 percent increase in the price of caviar? Why?

Both chicken and caviar would contribute to inflation, but the greater effect on the CPI
would be chicken due to the consumption base among the population.

2. Describe the three problems that make the CPI an imperfect measure of the cost of
living.

- Substitution Bias: Consumers may change their buying habits as prices change, which the
CPI might not fully capture.

- Introduction of New Goods: New products increase consumers' choices and welfare, which
the CPI may not adequately reflect.

- Unmeasured Quality Changes: Quality improvements in goods and services can also distort
the CPI measurement.

3. Does an increase in the price of imported French wine affect the CPI or the GDP
deflator more? Why?

An increase in the price of imported French wine would affect the CPI more than the GDP
deflator because it is a consumer good that is included in the CPI basket.

4. Over a long period, the price of a candy bar rose from $0.20 to $1.20. Over the same
period, the CPI rose from 150 to 300. Adjusted for overall inflation, how much did the
price of the candy bar change?

$0.20 * (300 / 150) = $0.20 * 2 = $0.40 - Therefore, adjusted for overall

inflation, the price of the candy bar changed from $0.20 to $0.40.

Problems And Applications

2. The residents of Vegopia spend all of their income on cauliflower, broccoli, and
carrots. In 2020, they spend a total of $200 for 100 heads of cauliflower, $75 for
50 bunches of broccoli, and $50 for 500 carrots. In 2021, they spend a total of
$225 for 75 heads of cauliflower, $120 for 80 bunches of broccoli, and $100 for
500 carrots.
a. Calculate the price of one unit of each vegetable in each year.
- Total spent on X / Number of X
For 2020
- Cauliflower: $200 / 100 = $2.00
- Broccoli: $75 / 50 = $1.50
- Carrot: $50 / 500 = $0.10
For 2021
- Cauliflower: $225 / 75 = $3.00
- Broccoli: $120 / 80 = $1.50
- Carrot: $100 / 500 = $0.20
b. Using 2020 as the base year, calculate the CPI for each year.
- CPI = ( Cost of Market Basket in Current Year / Cost of Market Basket in Base Year ) × 100

For 2020

- Cost of Market Basket = ($200 + $75 + $50) = $325

- CPI: ($325 / $325) × 100 = 100

For 2021

- Cost of Market Basket = ($225 + $120 + $100) = $445

- CPI: ($445 / $325) × 100 ≈ 137.69

c. What is the inflation rate in 2021?

- Inflation Rate = ((CPI in 2021 - CPI in 2020) / CPI in 2020) × 100

- ((137.69 - 100) / 100) × 100 ≈ 37.69%

3. Suppose that people consume only three goods, as shown in this table:
Tennis Balls Golf Balls Bottles of
 Gatorade
2020 price $2 $4 $1
2020 quantity 100 100 200
2021 price $2 $6 $2
2021 quantity 100 100 200

a. What is the percentage change in the price of each of the three goods?
- Percentage Change = ((New Price - Old Price) / Old Price) × 100
- Tennis: (($2 - $2) / $2) × 100 = (0 / 2) × 100 = 0%
- Golf: (($6 - $4) / $4) × 100 = ($2 / $4) × 100 = 50%
- Gatorade: (($2 - $1) / $1) × 100 = ($1 / $1) × 100 = 100%
b. Using a method similar to the CPI, compute the percentage change in the
overall price level.
- 2020 Cost of Market Basket = ($2 * 100) + ($4 * 100) + ($1 * 200) = $800
- 2021 Cost of Market Basket = ($2 * 100) + ($6 * 100) + ($2 * 200) = $1200
- (($1200 - $800) / $800) × 100 = 50%

5. A small nation idolizes the TV show The Voice. All they produce and consume
are karaoke machines and CDs, in the following amounts.
Karaoke Machines CDs
 Price Quantity Price Quantity
2020 $40 10 $10 30
2021 $60 12 $12 50

a. Using a method similar to the CPI, compute the percentage change in the
overall price level. Use 2020 as the base year and fix the basket at 1 karaoke
machine and 3 CDs.
- 2020 Cost of Market Basket = ($40 * 1) + ($10 * 3) = $40 + $30 = $70
- 2021 Cost of Market Basket = ($60 * 1) + ($12 * 3) = $60 + $36 = $96
- (($96 - $70) / $70) × 100 = 37.14%

b. Using a method similar to the GDP deflator, compute the percentage change
in the overall price level. Again, use 2020 as the base year.
For 2020
- Nominal GDP = ($40 * 10) + ($10 * 30) = $400 + $300 = $700
- Real GDP = ($40 * 10) + ($10 * 30) = $400 + $300 = $700
For 2021
- Nominal GDP = ($60 * 12) + ($12 * 50) = $720 + $600 = $1320
- Real GDP = ($40 * 12) + ($10 * 50) = $480 + $500 = $980
- GDP Deflator 2020 = ($700 / $700) × 100 = 100
- GDP Deflator 2021 = ($1320 / $980) × 100 ≈ 134.69
- ((134.69 - 100) / 100) × 100 ≈ 34.69%

c. Is the inflation rate in 2021 the same using the two methods? Explain why or
why not.
- The inflation rate in 2021 is not the same using the two methods. The CPI-like
method uses a fixed basket of goods, while the GDP deflator method uses the
entire output of the economy. Additionally, the CPI-like method accounts for
changes in the quantities of goods consumed, while the GDP deflator method
does not.

7. A dozen eggs cost $0.88 in January 1980 and $1.77 in January 2018. The
average hourly wage for production and nonsupervisory workers was $6.57
in January 1980 and $22.36 in January 2018.

a. By what percentage did the price of eggs rise?

- (1.77 – 0.88) / 0.88 * 100 = 101

b. By what percentage did the wage rise?

- (22,36 – 6,57) / 6,57 = ≈240.49%

c. In each year, how many minutes did a worker have to work to earn enough to
buy a dozen eggs?
- Minutes per X = ( Price of X / Hourly Wage ) * 60
- In January 1980: (0.88 / 6.57) * 60 = 8 minutes
- In January 2018: (1.77 / 22.36) * 60 = 5 minutes

d. Did workers' purchasing power in terms of rise or fall?

- Workers' purchasing power in terms of eggs has fallen. In 1980, it took about 8
minutes to earn enough to buy a dozen eggs, while in 2018, it only took about 5
minutes.