Principles of Economics
Final termTopic 2
Measuring the Cost of Living – Consumer
Price Index (CPI)
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 used to monitor changes in the cost of
living over time.
THE CONSUMER PRICE INDEX
When the CPI rises, the typical family has to
spend more money to maintain the same
standard of living.
How the Consumer Price Index Is
Calculated
Fix the Basket: Determine what prices are most
important to the typical consumer.
The Economic Agency identifies a basket of goods
and services the typical consumer buys.
How the Consumer Price Index Is
Calculated
Find the Prices: Find the prices of each of
the goods and services in the basket for each
point in time.
How the Consumer Price Index Is
Calculated
Compute the Basket’s Cost: Use the data
on prices to calculate the cost of the basket of
goods and services at different times.
How the Consumer Price Index Is
Calculated
Choose a Base Year and Compute the
Index:
Designate one year as the base year, making
it the benchmark against which other years
are compared.
Compute the index by dividing the price of the
basket in one year by the price in the base
year and multiplying by 100.
How the Consumer Price Index Is
Calculated
Compute the inflation rate: The inflation
rate is the percentage change in the price
index from the preceding period.
How the Consumer Price Index Is
Calculated
The Inflation Rate
The inflation rate is calculated as follows:
C P I in Y ear 2 - C P I in Y ear 1
In flatio n R ate in Y ear 2 = 100
C P I in Y ear 1
CPI Vs GDP deflator
GDP deflator & CPI give some what different information about
what’s happening to the overall level of prices in the economy.
Three Key Differences:
1.GDP deflator measures the prices of all goods and services
produced whereas CPI measures the prices of only the goods and
services bought by consumers.
2.GDP deflator includes only those goods produced domestically.
Imported goods are not a part of GDP and do not show up in the
GDP deflator.
3. CPI include imported goods.CPI is computed using a fixed
basket of goods whereas GDP deflator allows the basket of goods
to change over time as the composition of goods and services
changed
Problems in Measuring the Cost of Living-
CPI Biases
The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure of the
cost of living.
Problems in Measuring the Cost of Living
Substitution bias
Introduction of new goods
Problems in Measuring the Cost of Living-
CPI Biases
Substitution Bias
The basket does not change to reflect
consumer reaction to changes in relative
prices.
Consumers substitute toward goods that
have become relatively less expensive.
The index overstates the increase in
cost of living by not considering
consumer substitution.
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.
New products result in greater variety,
which in turn makes each dollar more
valuable.
Consumers need fewer dollars to
maintain any given standard of living.
Problems in Measuring the Cost of Living-
CPI Biases
The substitution bias, introduction of new
goods, cause the CPI to overstate 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.
Nominal & Real Interest rate
The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
It is the interest rate that a bank pays.
The real interest rate is the nominal interest rate
that is corrected for the effects of inflation.
Real Interest rate = Nominal interest rate –
Inflation rate
17
INFLATION
Inflation refers to a situation in which the economy’s
overall price level is rising.
The inflation rate is the percentage change in the price
level from the previous period.
Not all prices rise at the same rate during inflation.
Not everyone suffers equally from inflation.
Although inflation makes some people worse off, it makes
some people better off
Hyperinflation is an extraordinarily high rate of inflation such
as Germany experienced in the 1920s.
Hyperinflation is inflation that exceeds 50% per month
Types of Inflation
Demand-Pull Inflation
Demand-pull inflation results from excessive pressure
on the demand side of the economy.
“Too much money chases too few goods” enabling
producers to raise prices.
Cost-Push Inflation
The pressure on price could also originate on the
supply side.
Higher production costs put upward pressure on
product prices
Effects of Inflations [on..]
Consumers Producers Economy
Zero Not affected at all No incentive to Stagnant for
inflation produce more, almost same
Same production level of
production
Mild Affected but not Have incentive to Economy
Inflation much, produce more, expands as
Demand may be Higher production production
same increase
High Affected much, Producers of inelastic Economy
Inflation Demand may be products affected, squeezes as
lower in many Production lower for production falls
products lower demand
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.
The index is used to measure the overall
level of prices in the economy.
The percentage change in the CPI measures
the inflation rate.
Summary
The consumer price index is an imperfect
measure of the cost of living for the following
three reasons: substitution bias, and the
introduction of new goods.
