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Measuring the Cost of Living

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

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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
    • Bureau of Labor Statistics

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Calculating CPI

  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

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Calculating CPI

  1. Chose a base year and compute the CPI
    • Base year = benchmark
      • Price of basket of goods & services in current year
      • Divided by price of basket in base year
      • Times 100
  2. Compute the inflation rate

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Table 1

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Calculating the Consumer Price Index and the Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

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Table 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating the Consumer Price Index and the Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

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The Consumer Price Index

  • Inflation rate
    • Percentage change in the price index
      • From the preceding period
  • 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

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Figure 1

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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.

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GDP deflator versus CPI

  • 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

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GDP deflator versus CPI

  • 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

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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Figure 2

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 consumer price index using annual data since 1965. Notice that the two measures of inflation generally move together.

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Correcting Economic Variables

  • Dollar figures from different times

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  • Indexation
    • Automatic correction by law or contract
    • Of a dollar amount
    • For the effects of inflation
    • COLA
      • Cost of living allowance

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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

= Nominal interest rate – Inflation rate

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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

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Figure 3

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 3-month Treasury bill. The real interest rate is the nominal interest rate minus the inflation rate as measured by the consumer price index. Notice that nominal and real interest rates often do not move together.