Topic 2
Chapter 24
Measuring the Cost of Living
1
The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall level of prices
– Measure of the overall cost of goods and
services
– Bought by a typical consumer
– Computed and reported every month by
the Bureau of Labor Statistics
2
Calculating CPI (1/2)
1. Fix the basket
– Which prices are most important to the typical
consumer
– Different weight
2. Find the prices
– At each point in time
3. Compute the basket’s cost
– Same basket of goods
– Isolate the effects of price changes
3
Calculating CPI (2/2)
4. Chose a base year and compute the CPI
– Base year = benchmark
• Price of basket of goods and services in current
year
• Divided by price of basket in base year
• Times 100
5. Compute the inflation rate
4
Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
7
The Consumer Price Index (1/3)
• Inflation rate
– Percentage change in the price index
• From the preceding period
• Core CPI
– Measure of the overall cost of consumer
goods and services excluding food and
energy
8
The Consumer Price Index (2/3)
• Producer price index, PPI
– Measure of the cost of a basket of goods
and services bought by firms
– Changes in PPI are often thought to be
useful in predicting changes in CPI
9
Figure 1 The Typical Basket of Goods and Services
11
The Consumer Price Index (3/3)
• Problems in measuring the cost of living
– Substitution bias
• Prices do not change proportionately
• Consumers substitute toward goods that have
become relatively less expensive
– Introduction of new goods
• More variety of goods
– Unmeasured quality change
• Changes in quality
12
GDP Deflator Versus CPI (1/2)
• GDP deflator
– Ratio of nominal GDP to real GDP
– Reflects prices of all goods & services
produced domestically
• CPI
– Reflects prices of goods & services bought by
consumers
14
GDP Deflator Versus CPI (2/2)
• GDP deflator
– Compares the price of currently produced goods
and services
• To the price of the same goods and services in the
base year
• CPI
– Compares price of a fixed basket of goods and
services
• To the price of the basket in the base year
15
Figure 2 Two Measures of Inflation
17
Correcting Economic Variables (1/2)
• Dollar figures from different times
A price index such as the CPI
– Measures the price level and thus
determines the size of the inflation
correction
18
Regional Differences in the Cost of Living (1/2)
• The cost of living varies
– Not only over time
– But also over geography
• Regional price parities
– Measure variation in the cost of living
from state to state.
19
Figure 3 Regional Variation in the Cost of Living
21
Regional Differences in the Cost of Living (2/2)
• Regional differences explained by
– Prices of goods – small part
– Prices of services – larger part
– Housing services – persistently large
22
Correcting Economic Variables (2/2)
• Indexation
– Automatic correction by law or contract
– Of a dollar amount
– For the effects of inflation
– COLA: Cost-of-living allowance
23
Real and Nominal Interest Rates
• Nominal interest rate
– Interest rate as usually reported
– Without a correction for the effects of inflation
• Real interest rate
– Interest rate corrected for the effects of inflation
= Nominal interest rate – Inflation rate
24
Interest Rates in the U.S. Economy
• Nominal interest rate
– Always exceeds the real interest rate
– U.S. economy has experienced rising
consumer prices in every year
• Inflation is variable
– Real and nominal interest rates do not always
move together
• Periods of deflation
– Real interest rate exceeds the nominal interest
rate
25
Figure 4 Real and Nominal Interest Rates
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