Chapter 11

Measuring the cost of living

Reference book-Mankiw

Sabakun Naher Shetu

Assistant Professor
Dept. of Marketing
FBS, JU
 The Consumer Price Index

• Consumer Price Index (CPI)

“a measure of the overall cost of the goods and services
bought by a typical consumer”
 How the CPI is calculated

• Step 1: fix the basket

• Step 2: find the prices
• Step 3: compute the basket’s cost
• Step 4: choose a base year and compute the index

• Step 5: compute the inflation rate

Continued….
 CONTINUED…

• 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: a measure of the cost of a basket of
goods and services bought by firms
 Problems in measuring the cost
of living
• First problem: substitution bias
• Second problem: introduction of new goods
• Third problem: CPI is an unmeasured quality change

BANGLADESH BUREAU OF STATISTICS

• https://bbs.gov.bd/site/page/29b379ff-7bac-41d9-b321-e4
1929bab4a1/-
 Continued…. substitution bias
• When prices change from one year to the next, they do not all
change proportionately: Some prices rise more than others.
Consumers respond to these differing price changes by buying
less of the goods whose prices have risen by relatively large
amounts and by buying more of the goods whose prices have
risen less or perhaps even have fallen. That is, consumers
substitute toward goods that have become relatively less
expensive. If a price index is computed assuming a fixed basket
of goods, it ignores the possibility of consumer substitution
and, therefore, overstates the increase in the cost of living from
one year to the next.
 Continued….
• Let’s consider a simple example. Imagine that in the base year,
apples are cheaper than pears, so consumers buy more apples
than pears. When the BLS constructs the basket of goods, it will
include more apples than pears. Suppose that next year pears are
cheaper than apples. Consumers will naturally respond to the
price changes by buying more pears and fewer apples. Yet when
computing the CPI, the BLS (USA) [BD-BANGLADESH BUREAU OF
STSTISTICS] uses a fixed basket, which in essence assumes that
consumers continue buying the now expensive apples in the same
quantities as before. For this reason, the index will measure a
much larger increase in the cost of living than consumers actually
experience.
 Continued…. introduction of new goods
• When a new good is introduced, consumers have more variety from
which to choose, and this in turn reduces the cost of maintaining the
same level of economic well being. To see why, consider a hypothetical
situation: Suppose you could choose between a $100 gift certificate at
a large store that offered a wide array of goods and a $100 gift
certificate at a small store with the same prices but a more limited
selection. Which would you prefer? Most people would pick the store
with greater variety. In essence, the increased set of possible choices
makes each dollar more valuable. The same is true with the evolution
of the economy over time: As new goods are introduced, consumers
have more choices, and each dollar is worth more. But because the CPI
is based on a fixed basket of goods and services, it does not reflect the
increase in the value of the dollar that arises from the introduction of
new goods.
 Continued….
• Let’s consider an example. When the iPod was introduced in 2001,
consumers found it more convenient to listen to their favorite music.
Devices to play music were available previously, but they were not nearly
as portable and versatile. The iPod was a new option that increased
consumers’ set of opportunities. For any given number of dollars, the
introduction of the iPod made people better off; conversely, achieving the
same level of economic well-being required a smaller number of dollars. A
perfect cost-of-living index would have reflected the introduction of the
iPod with a decrease in the cost of living. The CPI, however, did not
decrease in response to the introduction of the iPod. Eventually, the BLS
revised the basket of goods to include the iPod, and subsequently, the
index reflected changes in iPod prices. But the reduction in the cost of
living associated with the initial introduction of the iPod never showed up
in the index.
 Continued…. unmeasured quality change
• If the quality of a good deteriorates from one year to the next while
its price remains the same, the value of a dollar falls, because you
are getting a lesser good for the same amount of money. Similarly,
if the quality rises from one year to the next, the value of a dollar
rises. The BLS does its best to account for quality change. When the
quality of a good in the basket changes—for example, when a car
model has more horsepower or gets better gas mileage from one
year to the next—the Bureau adjusts the price of the good to
account for the quality change. It is, in essence, trying to compute
the price of a basket of goods of constant quality. Despite these
efforts, changes in quality remain a problem because quality is hard
to measure.
 The GDP Deflator vs the Consumer Price Index

• The first difference is that the GDP deflator reflects the prices
of all goods and services produced domestically, whereas the
CPI reflects the prices of all goods and services bought by
consumers.
 Continued….
• For example, suppose that the price of an airplane produced by
Boeing and sold to the Air Force rises. Even though the plane is
part of GDP, it is not part of the basket of goods and services
bought by a typical consumer. Thus, the price increase shows up
in the GDP deflator but not in the CPI.
• As another example, suppose that Volvo raises the price of its
cars. Because Volvos are made in Sweden, the car is not part of
U.S. GDP. But U.S. consumers buy Volvos, so the car is part of the
typical consumer’s basket of goods. Hence, a price increase in an
imported consumption good, such as a Volvo, shows up in the CPI
but not in the GDP deflator.
 Continued…
• The second and subtler difference between the GDP deflator
and the CPI concerns how various prices are weighted to
yield a single number for the overall level of prices.
• The CPI 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 of goods.
By contrast, 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.
Continued….

• Thus, the group of goods and services used to compute the

GDP deflator changes automatically over time. This difference
is not important when all prices are changing proportionately.
But if the prices of different goods and services are changing
by varying amounts, the way we weight the various prices
matters for the overall inflation rate.
 Correcting Economic variables for the effects of Inflation

• Babe Ruth’s salary was $80,000 in 1931 high or low compared

to the salaries of today’s players?
 Continued…
• Let’s apply this formula to Ruth’s salary. Government statistics show a CPI
of 15.2 for 1931 and 237 for 2015. Thus, the overall level of prices has risen
by a factor of 15.6 (calculated from 237/15.2). We can use these numbers
to measure Ruth’s salary in 2015 dollars.
Any Query
?!