Measuring the Cost of Living

• Chapter 24: Measuring the Cost of Living
  • 24-1: The Consumer Price Index
• 24-2: Correcting Economic Variables for the Effects of Inflation

Chapter 24: Measuring the Cost of Living

24-1: The Consumer Price Index

• Consumer price index (CPI): The measure of the overall cost of goods and services bought by a typical consumer

How The CPI Is Calculated

• The Bureau of Labor Statistics (BLS) uses a few steps to calculate the CPI

1. Fix the basket
   • The prices most important to the typical consumer are taken into account
   • Goods and services that are purchased more are given a greater weight when calculating the CPI
   • Important goods and services found through surveys
2. Find the prices
   • Find the prices of the baskets’ goods and services at each point in time that you want to caluclate
3. Compute the basket’s cost
   • Use the data on the prices and multiply each price by the good/service’s weight
4. Choose a base year and compute the index
   • After choosing a base year, you can calculate the CPI by comparing the price of a basket from the current year to the base year
   • $$| { \text{CPI} = {\text{Price of basket of goods and services in current year} \over \text{Price of basket in base year}} * 100 } |$$
5. Compute the inflation rate
   • Can use the CPI to calculate the inflation rate from year to year
   • $| { \text{Inflation rate in year 2} = {\text{CPI in year 2 - CPI in year 1} \over \text{CPI in year 1}} * 100 } |$ - Example of following the steps: - The CPI is useful to find the cost of living for the average consumer - The core CPI is similar to the CPI except it excludes food and energy, as they have higher volatility - The producer price index (PPI) measures the cost of a basket of goods and services bought by producers rather than consumers
   • Changes in PPI are often thought to be useful to predict changes in CPI

Problems in Measureing the Cost of Living

• There are many issues with the CPI that are difficult to solve
• Substitution Bias
  • Some prices might rise higher than others, and if said prices become too high, then consumers will substitute those expensive goods and services with cheaper ones
  • Because the goods and services are substituted, the goods and services in the basket change weight drastically, but the base year always uses a fixed basket, so the CPI might not reflect these new changes
• Introduction of New Goods
  • If a new good is introduced, then the buying power of a dollar increases
  • Since the basket is fixed to a base year, the new product that is introduced is not included in the basket, and the CPI does not accurately reflect the new change
• Unmeasured Quality Change
  • A good or service can increase or decrease in quality without the price of it changing
  • Quality is hard to measure and thus cannot be accurately reflected in the CPI
• The accuracy is extremely important for the government; services such as Social Security give out money based on the CPI
  • Economists argue on how to balance it to make it more accurate

The GDP Deflator versus the Consumer Price Index

• The GDP deflator and the CPI both reflect changes in prices, but there are two key differences between them
  • The GDP deflator reflects the prices of all goods and services produced domestically while the CPI reflects the prices of all goods and services purchased by consumers
    • For instance, if the price of oil increases, then the CPI will rise much more than the GDP deflator
  • The weighting of the GDP deflator and the CPI differs
    • The CPI does not change the goods and services in its fixed basket, but the GDP deflator measures all currently produced goods and services so it changes more often

24-2: Correcting Economic Variables for the Effects of Inflation

Dollar Figures from Different Times

• You can calculate the value of a dollar using the following formula
  • $${ \text{Amount in today's dollars} = \text{Amount in year T dollars} * {\text{Price level today} \over \text{Price level in year T}} }$$

Indexation

• A price that is corrected to reflect inflation is said to be indexed, and indexation is typically done through a law or a contract
• Many laws use indexation, such as Social Security

Real and Nominal Interest Rates

• An interest rate means that your money increases over time, but the purchasing power of said new dollar is effected by inflation
• If your money increases through an interest rate, it may have less or more purchasing power if the inflation rate is higher than the interest rate
• Two types of interest rates: nominal interest rate, which does not correct for the effects of inflation, and real interest rate, which does
  • Real interest rate = Nominal interest rate - Inflation rate