Principles of

Economics, 10e
Chapter 25: Measuring the
Cost of Living

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or duplicated, or posted to a publicly accessible website, in whole or in part. 1

Chapter Objectives (1 of 2)

By the end of this chapter, you should be able to:

• Explain the welfare effects of inflation in a given scenario.
• Calculate the annual inflation rate for a specified year, given CPI data.
• Explain the differences between the GDP deflator and the CPI.
• Calculate the CPI, given pricing and consumption data on a fixed basket
of goods.
• Explain why the producer price index is useful in predicting changes in
the consumer price index.

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or duplicated, or posted to a publicly accessible website, in whole or in part. 2
 Chapter Objectives (2 of 2)

• Determine how a scenario will cause the CPI to bias the true cost of
living.
• Compare the value of a dollar in the past to the value of a dollar today.
• Describe the relationship between the nominal interest rate, inflation,
and the real interest rate.

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or duplicated, or posted to a publicly accessible website, in whole or in part. 3

25-1
The Consumer Price Index

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 The Consumer Price Index (CPI)

• Consumer price index*

• A measure of the overall cost of the goods and services bought by a
typical consumer
• Monitors changes in the cost of living over time
• Computed and reported every month by the Bureau of Labor
Statistics

*Words accompanied by an asterisk are key terms from the chapter.

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or duplicated, or posted to a publicly accessible website, in whole or in part. 5

How the CPI Is Calculated (1 of 2)

1. Fix the basket

• The Bureau of Labor Statistics (BLS) surveys consumers to find the
basket of goods and services bought by the typical consumer
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
• Isolate the effects of price changes

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 How the CPI Is Calculated (2 of 2)

4. Chose a base year and compute the index

• Designate a year as base year (benchmark)

Basket's cost in current year  CPI in year 1

CPI   100
Basket's cost in base year

5. Compute the inflation rate

CPI in year 2잺 PI in year 1

Inflation rate in year 2   100
CPI in year 1

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or duplicated, or posted to a publicly accessible website, in whole or in part. 7

Table 1 Calculating the Consumer Price Index

and the Inflation Rate: An Example (1 of 3)
This table shows how to calculate the CPI and the inflation rate for a
hypothetical economy in which consumers buy only hot dogs and hamburgers.
Step 1: Survey Consumers to Determine a Fixed
• Basket of Goods Basket = 4 hot dogs, 2 hamburgers
Step 2: Find the Price of Each Good in Each Year

Year Price of Hot Dogs Price of Hamburgers

2022 $1 $2
2023 $2 $3
2024 $3 $4

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 Table 1 Calculating the Consumer Price Index
and the Inflation Rate: An Example (2 of 3)
Step 3: Compute the Cost of the Basket of Goods in Each Year
2022 ($1 per hot dog × 4 hot dogs) + ($2 per hamburger × 2 hamburgers) = $8 per basket
2023 ($2 per hot dog × 4 hot dogs) + ($3 per hamburger × 2 hamburgers) = $14 per basket
2024 ($3 per hot dog × 4 hot dogs) + ($4 per hamburger × 2 hamburgers) = $20 per basket

Step 4: Choose One Year as a Base Year (2022) and Compute the CPI in Each Year
2022 ($8/$8) × 100 = 100
2023 ($14/$8) × 100 = 175
2024 ($20/$8) × 100 = 250

Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 9

Table 1 Calculating the Consumer Price Index

and the Inflation Rate: An Example (3 of 3)
Step 5: Use the CPI to Compute the Inflation Rate from Previous Year

2023 (175 − 100)/100 × 100 = 75%

2024 (250 − 175)/175 × 100 = 43%

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 Figure 1 The Typical Basket of Goods and
Services
This figure shows how the typical consumer divides spending among various categories
of goods and services. The Bureau of Labor Statistics calls each percentage the
“relative importance” of the category.

Source: U.S. Department of Labor; U.S. Department of Commerce.

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Active Learning 1: CPI & Inflation Rate

Year Price of Beef Price of Chicken

2021 $3 $3
2022 $4 $4
2023 $8 $5

CPI basket: 10 lbs of beef, 20 lbs of chicken

Base year: 2021
A. Calculate CPI for all years.
B. What was the inflation rate from 2022-2023?

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 Active Learning 2: New Basket, CPI &
Inflation Rate
Year Price of Beef Price of Chicken
2021 $3 $3
2022 $4 $4
2023 $8 $5

New CPI basket for 2023: 5 lbs of beef, 25 lbs of chicken

Base year: 2021
A. Calculate cost of new basket for 2023 and CPI for 2023.
B. What is the new inflation rate from 2022-2023?

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or duplicated, or posted to a publicly accessible website, in whole or in part. 13

Measures of Inflation

• Inflation rate*
• The 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
• 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
*Words accompanied by an asterisk are key terms from the chapter.

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 Problems in Measuring the Cost of Living

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

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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
• Thus, the CPI overstates increases in the cost of living

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 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
• Thus, the CPI overstates increases in the cost of living

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or duplicated, or posted to a publicly accessible website, in whole or in part. 17

Unmeasured Quality Change

• Improvements in the quality of goods in the basket increase the value

of each dollar
• 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

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or duplicated, or posted to a publicly accessible website, in whole or in part. 18
 The GDP Deflator versus the Consumer
Price Index
• GDP deflator • CPI
• Ratio of nominal GDP to real • Reflects prices of goods &
GDP services bought by consumers
• Reflects prices of all goods & • Compares price of a fixed
services produced basket of goods and services
domestically to price of the basket in the
base year
• Compares price of currently
produced goods and services
to price of the same goods
and services in the base year
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or duplicated, or posted to a publicly accessible website, in whole or in part. 19

Figure 2 Two Measures of Inflation

This figure shows the inflation rate—the percentage change in the level of
prices— as measured by the GDP deflator and the CPI using annual data since
1965. Notice that the two measures of inflation generally move together.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 20
 25-2
Correcting Economic Variables for the
Effects of Inflation

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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
Price level today
Amount in today뭩 dollars Amount in yearT dollars x
Price level in year T

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 Figure 3 Regional Variation in the Cost of Living

This figure shows how

the costs of living in
the 50 U.S. states and
the District of
Columbia compare to
the U.S. average.

Source: U.S. Department

of Commerce

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or duplicated, or posted to a publicly accessible website, in whole or in part. 23

Indexation

• Indexation*
• The automatic correction by law or contract of a dollar amount for
the effects of inflation
• The increase in CPI automatically determines
• The COLA (cost-of-living-allowance) in many multi-year labor
contracts
• Adjustments in Social Security payments and federal income tax
brackets
*Words accompanied by an asterisk are key terms from the chapter.

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 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
Real interest rate = Nominal interest rate - Inflation rate

*Words accompanied by an asterisk are key terms from the chapter.

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Figure 4 Real and Nominal Interest Rates

This figure shows nominal and
real interest rates using annual
data since 1965. The nominal
interest rate is the rate on a
three-month Treasury bill. The
real interest rate is the
nominal interest rate minus
the inflation rate as measured
by the CPI. Notice that nominal
and real interest rates often do
not move together.

Source: U.S. Department of Labor; U.S. Department of Treasury.

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 Think-Pair-Share Activity

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.”

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?

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or duplicated, or posted to a publicly accessible website, in whole or in part. 27

Self-Assessment

• Does an increase in the price of imported goods affect the CPI or the
GDP deflator more? Why?

Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 28