chap16 cost of living

8/10/2019 Chap16 Cost of Living

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16Measuring the Costof Living


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Copyright2004 South-Western

Context

Continue to study how economists measure output and prices in the macroeconomy.

Previous lecture addressed how economists measure output. Today we discuss how economists measure the overall price

level in the macroeconomy. The purpose of todays lecture:

Introduce the price index

Show how to use a price index for comparing dollar figuresfrom different points in time and for adjusting interest rates forinflation.

Show the shortcomings of using the consumer price index as ameasure of the cost of living.


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Measuring the Cost of Living

Overall level of prices in the economy Need some kind of measures for the overall level of

prices and for the change in price level

Inflation refers to a situation in which theeconomys overall price level is rising.

The inflation rate is the percentage change in the

price level from the previous period.


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THE CONSUMER PRICE INDEX

The consumer price index (CPI) is ameasure of the overall cost of the goods andservices bought by a typical consumer. It is used to monitor changes in the cost of

living over time. When the CPI rises, the typical family has to spend

more dollars to maintain the same standard ofliving.

The Bureau of Labor Statistics reports the CPI

each month.


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How to Calculate the Consumer Price Index?(5 steps)

1. F ix the Basket: Determine what prices are mostimportant for the typical consumer.

The Bureau of Labor Statistics (BLS) identifies a

market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set

the weights for the prices of those goods and

services.2. F ind the Prices: Find the price of each of the

goods and services in the basket for each point

in time.


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How the Consumer Price Index Is Calculated(5 steps)

3. Compute the Baskets Cost: Use the data on prices to calculate the cost of the

basket of goods and services at different times.

4. Choose a Base Year and Compute the CPI : Designate one year as the base year, making it the

benchmark against which other years arecompared.

Compute the CPI by dividing the price of the basketin one year by the price of the basket in the base yearand multiplying by 100.


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How the Consumer Price Index Is Calculated(5 steps)

5. Compute the inf lation rate: The inflation rate is the percentage change in the

price index from the preceding period.

The inf lation rate is calculated as follows:

It is possible for the CPI to fall if deflation is present. Have you experienced deflation in your lifetimes? It has occurred during several periods of U.S. history

(especially during the Great Depression).


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Calculating the Consumer Price Index and the Inflation Rate:

201020112012

201020112012

201020112012

20112012



One more example


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FYI: Whats in the U.S. CPIs Basket?

16% Food and beverages

17% Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goods

and services

4%

41% Housing

6% Education and

communication



CNN Video: What the Fed Watches

1. How is inflation measured? The most widely used measure of inflation is the CPI. The CPI measures changes in the prices of a market

basket of goods and services representative of whatwould be purchased by urban consumers and theirfamilies.

Prices for this market basket are measured each monthand compared to the same basket in a base year.

The percentage change in this number from one periodof time to another is the measure of inflation.

2. Why is inflation so widely feared?



Other Price Indices

The BLS calculates other prices indices: The index for different regions within the country. The producer price index (PPI), which measures the

cost of a basket of goods and services bought by f irms rather than consumers. The PPI is helpful in predicting changes in the CPI.

Because firms eventually pass on higher costs to consumers

in the form of higher prices on products Jet fuel prices increase leads to higher prices for airline tickets.



Problems in Measuring the Cost of Living

The CPI is an accurate measure of the selectedgoods that make up the typical bundle, but it isnot a perfect measure of the cost of living.

Specific problems with the CPI: Substitution bias Introduction of new goods

Unmeasured quality changes




Substitution Bias The consumption 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.




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. Cellular telephony

Internet-based media




Unmeasured Quality Changes If the quality of a good rises from one year to the next,

the value of a dollar rises , even if the price of the goodstays the same.

If the quality of a good falls from one year to the next,the value of a dollar falls , even if the price of the goodstays the same.

The BLS tries to adjust the price for constant quality, but such differences are hard to measure.




The substitution bias, introduction of new goods,and unmeasured quality changes cause the CPI tooverstate the true cost of living .

The issue is important because many government programs use the CPI to adjust for changes in theoverall level of prices.

The CPI overstates inflation by about 1 percentage point per year.



The GDP Deflator versus the ConsumerPrice Index

Recall from previous lecture that the GDP deflatoris calculated as follows:

GDP deflator = Nominal GDP

Real GDP 100



The GDP Deflator versus the ConsumerPrice Index

Economists and policymakers monitor both theGDP deflator and the consumer price index togauge how quickly prices are rising.

There are two important differences between theindexes which cause the divergence betweenthem.



The GDP Deflator versus the ConsumerPrice Index (1)

The GDP deflator reflects the prices of all goodsand services produced domestically , whereas...

the consumer price index reflects the prices of

all goods and services bought by consumers . Imported goods are in the CPI basket but do not count

for the GDP.



The GDP Deflator versus the ConsumerPrice Index (2)

The consumer price index compares the price of a fixed basket of goods and services to the price ofthe same basket in the base year (only

occasionally does the BLS change the basket)... whereas the GDP deflator compares the price

of currently produced goods and services to the price of the same goods and services in the baseyear. This means that the group of goods and services used

to compute the GDP deflator changes automaticallyover time as output changes.



Two Measures of Inflation , 1960 2012

P e r c e n

t c

h a n g e p e r y e a r

-5

0

5

10

15

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

GDP deflator CPI



Imported consumer goods:

included in CPI excluded from GDP deflator

The basket:CPI uses fixed basketGDP deflator uses basket ofcurrently produced goods & services

This matters if different prices arechanging by different amounts.

Capital goods:

excluded from CPIincluded in GDP deflator (if produced domestically)

Contrasting the CPI and GDP Deflator



A C T I V E L E A R N I N G 3 CPI vs. GDP deflator

In each scenario, determine the effects on theCPI and the GDP deflator.A. Starbucks raises the price of Frappuccinos.

B. Caterpillar raises the price of the industrial tractorsit manufactures at its Illinois factory.

C. Armani raises the price of the Italian jeans it sells in

the U.S.


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A C T I V E L E A R N I N G 3 Answers

A. Starbucks raises the price of Frappuccinos.The CPI and GDP deflator both r ise.

B. Caterpillar raises the price of the industrialtractors it manufactures at its Illinois factory.The GDP deflator r ises, the CPI does not.

C. Armani raises the price of the Italian jeans itsells in the U.S.The CPI r ises, the GDP deflator does not.


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CORRECTING ECONOMIC VARIABLESFOR THE EFFECTS OF INFLATION

Price indexes are used to correct for the effects ofinflation when comparing dollar figures fromdifferent times.

To adjust dollar value from one year to the next,we can use this formula:


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Dollar Figures from Different Times

Do the following to convert (inflate) Babe Ruthswages in 1931 to dollars in 2010: Keep in mind that CPI = 15.2 in 1931, CPI = 220.3 in 2010

1,159,473$15.2220.3000,80$

1931inLevelPrice2010inLevelPrice

SalarySalary 19312010


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Another Example

Your father graduated from school and took hisfirst job in 1972, which paid a salary of $7,000.

What is this salary worth in 2010 dollars?

CPI in 1972 = 41.8 CPI in 2010 = 220.3

Value in 2006 dollars = 1972 salary (CPI in 2010/CPI in 1972)

Value in 2006 dollars = $7,000 (220.3/41.8) = $7,000 5.27

= $36,892


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$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

D o

l l a r s p e r

h o u r

The U.S. Minimum Wage in Current Dollarsand Todays Dollars, 1960 2012

2012 dollars

current dollars


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Why the do we see the sawtooth patternin the real minimum wage series?

After the nominal minimum wage is raised, it remainsconstant until its raised again. During the time between minimum wage hikes, inflation

erodes the purchasing power of the minimum wage. The long-run trend in the real minimum wage:

Rising during the 1960s, Then a long, slow fall from the 1970s to the mid-2000s.

A series of increases in the late 2000s lift the real minimumwage. But, as of December 2010, the real minimum wage is still lower

than it was in the 1960s to the early 1980s.


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A C T I V E L E A R N I N G 4 Comparing tuition increases

Tuition and Fees at U.S. Colleges and Universities

1990 2010

Private non-profit 4-year $9,340 $27,293

Public 4-year $1,908 $7,605

Public 2-year $906 $2,713

CPI 130.7 218.1

Instructions: Express the 1990 tuition figures in 2010dollars, then compute the percentage increase for all threetypes of schools. Which type experienced the largest

increase in real tuition costs?


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A C T I V E L E A R N I N G 4 Answers

1990 2010 % changeCPI 130.7 218.1 66.9%

Private non-profit 4-year (current $) $9,340 $27,293

Private non-profit 4-year (2010 $) $15,586 $27,293 75.1%

Public 4-year (current $) $1,908 $7,605

Public 4-year (2010 $) $3,184 $7,605 138.9%

Public 2-year (current $) $906 $2,713

Public 2-year (2010 $) $1,512 $2,713 79.4%


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Correcting Variables for Inflation:Real vs. Nominal Interest Rates

The nominal interest rate: the interest rate not corrected for inflation

the rate of growth in the dollar value of adeposit or debt

The real interest rate: corrected for inflation

the rate of growth in the purchasing power of adeposit or debt

Real interest rate

= (nominal interest rate) (inflation rate)


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Correcting Variables for Inflation:Real vs. Nominal Interest Rates

Example: Deposit $1,000 for one year.

Nominal interest rate is 9%.

During that year, inflation is 3.5%.

Real interest rate= Nominal interest rate Inflation

= 9.0% 3.5% = 5.5% The purchasing power of the $1000 deposit

has grown 5.5%.


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Real and Nominal Interest Rates in the U.S.,1950 2012

-10

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

I n

t e r e s

t r a

t e

( p e r c e n

t p e r y e a r

)

Nominal Real

The nominal interest rate is the rate on a three-month Treasury Bill. Note that in the late 1970s, the real interest rate was negative

because the inflation rate exceeded the nominal interest rate.


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Summary

The consumer price index shows the cost of a basket of goods and services relative to the cost ofthe 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.


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Summary

The consumer price index is an imperfect measureof the cost of living for the following threereasons: substitution bias, the introduction of newgoods, and unmeasured changes in quality.

Because of measurement problems, the CPIoverstates annual inflation by about 1 percentage

point.


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Summary

The GDP deflator differs from the CPI because itincludes goods and services produced rather thangoods and services consumed.

In addition, the CPI uses a fixed basket of goods,while the GDP deflator automatically changes thegroup of goods and services over time as thecomposition of GDP changes.


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Summary

Dollar figures from different points in time do notrepresent a valid comparison of purchasing power.

Various laws and private contracts use price

indexes to correct for the effects of inflation. The real interest rate equals the nominal interest

rate minus the rate of inflation.

chap16 cost of living

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