cpi and other indices.pdf

7/29/2019 CPI and other indices.pdf

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Measuring the Cost of

Living


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Measuring the Cost of Living Inflation refers to a situation in which the

economys overall price level is rising.

The inflation rate is the percentage changein the price level from the previous period.


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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. It is used to monitor changes in the cost of

living over time.


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WHAT CPI MEASURES? It measures Price changes of fixed market

basket of goods and services of constantquality and quantity.

It tells how much cost of living has risen or

fallen due to price changes irrespective ofchanges in consumer behaviour or qualityof goods.

It does not reflect the cost of living or in

house hold consumption expenditure assuch but only the influence of pricefluctuation on the trend.


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The Consumer Price IndexWhen the CPI rises, the typical

family has to spend more dollars to

maintain the same standard of

living.


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Consumer Price Index

Consumer Price Index is the main measure

of price changes at the retail level. It measures

changes in the cost of buying a representative

fixed basket of goods and services and isgenerally accepted as a measure of inflation in

the country.


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How the Consumer Price Index Is

Calculated Fix the Basket: Determine what prices

are most important to 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.


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Calculated

Find the Prices: Find the prices of each ofthe goods and services in the basket for

each point in time.


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Calculated

Compute the Baskets Cost: Use the dataon prices to calculate the cost of the

basket of goods and services at different

times.


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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 thebasket in one year by the price in the base year

and multiplying by 100.


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Calculated

Compute the inflation rate: The inflationrate is the percentage change in the price

index from the preceding period.


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The Inflation Rate

The inflation rateis calculated as follows:

1001YearinCPI

1YearinCPI-2YearinCPIYear2inRateInflation


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Calculating the Consumer Price Index and the

Inflation Rate: An Example

Step 1:Survey Consumers to Determine a Fixed

Basket of Goods

4 hot dogs, 2 hamburgers


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Calculating the Consumer Price Index and the Inflation

Rate: An Example

Year

Price of

Hot dogs

Price of

Hamburgers

2001 $1 $2

2002 $2 $3

2003 $3 $4

Step 2: Find the Price of Each Good in Each Year


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Calculating the Consumer Price Index and the

Inflation Rate: An Example

2001 ($1 per hot dog x 4 hot dogs) + ($2 per hamburger x 2 hamburgers) = $8



Step 3: Compute the Cost of the Basket of Goods in

Each Year


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Rate: An ExampleStep 4: Choose One Year as the Base Year (2001) and

Compute the Consumer Price Index in Each Year

2001 ($8/$8) x 100 =1002002 ($14/$8) x 100 =175

2003 ($20/$8) x 100 = 250


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Rate: An Example

2002 (175-100)/100 x 100 = 75%

2003 (250-175)175 x 100 = 43%

Step 5: Use the Consumer Price Index to Compute the

Inflation Rate from Previous Year


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Rate: Another Example Base Year is 1998.

Basket of goods in 1998 costs $1,200.

The same basket in 2000 costs $1,236.

CPI = ($1,236/$1,200) X 100 = 103.

Prices increased 3 percent between 1998

and 2000.


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GDP DeflatorThe GDP deflator is calculated as follows:

100GDPReal

GDPNominal=deflatorGDP


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Housing

Food/Beverages

Transportation

Medical Care

Apparel

Recreation

Other

Education andcommunication

Whats in the CPIs Basket?

40%

16%

17%

6%

5%6%

5% 5%

h f


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Weights for CPI

The results of Family Budget Survey provide the average

percentage expenditure(Consumption pattern) of Households oneach item/each commodity group and for each income group for

the cities covered in CPI. These average percentage expenditures

on item and commodity groups are called weights and are being

used in computation of the CPI.Po x qo

Wi = ------------- x 100

Po x qo

Example: 1. Total Expenditure: Rs. 3000,

2. Expenditure on Wheat Flour:- Rs. 100

3. % of Expenditure on Wheat flour = (100/3000)*100 = 3.33

Weight of Wheat flour = 3.33%

F E l C di G Wi I d


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For Example: Commodity Groups Wise Items and

Weights C.P.I (2000-01)

Commodity Group Weights Items

01. Food, Beverages & Tobacco 40.34 124

02. Apparel, Textile & Footwear 6.10 42

03. House Rent 23.43 01

04. Fuel & Lightening 7.29 15

05. House Hold, Furniture & Equipment etc. 3.29 44

06. Transport & Communication 7.32 42

07. Recreation & Entertainment 0.83 16

08. Education 3.45 24

09. Cleaning, Laundry & Personal Appearance 5.88 26

10. Medicines/Medicare 2.07 29

TOTAL 100.00 374


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FORMULA USED FOR COMPUTATION OF CPI

Laspeyre's formula as given below is being used forthe computation of CPI.

(Pn/Po) x wi

In = --------------------- x 100

wiWhere In = CPI for the nth period

Pn = price of an item in the in the nth period

Po = price of an item in the base period

wi = weight of the ith item in the base period =Po x qo / Po x Qo

wi = Total weight of all items.


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EXAMPLE FOR COMPUTATION OF CPI

ITEM UNITBASEPRICE(Po)

PRICE INMAR, 06(Pn)

WEIGHT(Wi)

Pn/ PoPo/ Pn

x Wi

Moong Pulse Kg 29.91 47.61 0.2230 1.5918 0.3550

Mash Pulse Kg 45.01 52.72 0.2017 1.1713 0.2363

Masoor Pulse Kg 36.23 44.03 0.2214 1.2153 0.2691

Gram Pulse Kg 28.99 31.50 0.4272 1.0866 0.4642

1.0733 1.3246

(Pn/Po) x WiIndex = -------------------------------- x 100

Wi

1.3246I = -------------------------- x 100 = 123.41

1.0733


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Other Price Indexes The BLS calculates other prices

indexes:

The index for different regions within thecountry.

The producer price index, which

measures the cost of a basket of goodsand services bought by firms rather than

consumers.


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SENSITIVE PRICE INDICATOR (SPI)

Sensitive Price Indicator (SPI) is designed to

assess price movement of essential consumer

items at short intervals (on weekly basis ).


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WHOLE SALE PRICE INDEX (WPI)

Wholesale price index ( WPI) isdesigned to measure the change ofprice in the primary and wholesale

markets.


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WEIGHTS FOR WPI

The value of marketable surplus is being used forderiving weights of commodities/items included inWPI. The value of marketable surplus is the value ofcommodity available for sale in wholesale market. It

is equal to the total value of production lessconsumption by the producers less exports (if any)plus imports.

Example:- Production Self Consumption +Imports- Exports

Wheat = (100 )-(20) + (10) (10) =80

Value of Marketing Surplus= 80 x 1000 = 80000

Total Value of all the Items included in WPI =100,0000

% of Wheat in Total Value = (80000/1000000) x 100 = 8%


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Why Three Types of Indices?

CPImeasures Inflation rate in the country

SPIis computed to assess the price movement

of essential commodities at short interval oftime to review the price situation in the

country.

WPImeasures the General Price level in thewhole sale market.


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Limitation of CPI

1) Coverage is limited2) Only covers Urban Centres

3) Prices may have different trend in rural &

urban centres.4) Rent is computed through construction

input items index instead of rent survey.

5) It measures partially inflation not totalconsumers expenditure.


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Problems in Measuring The Cost of

LivingThe 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.


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Problems in Measuring The Cost of

Living Substitution bias

Introduction of new goods Unmeasured quality changes


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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 ofliving by not considering consumer

substitution.


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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 anygiven standard of living.


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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 good stays 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 good stays the same.


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Unmeasured Quality ChangesThe BLS tries to adjust the price forconstant quality, but such

differences are hard to measure.


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Problems in Measuring the Cost of Living The substitution bias, introduction of new

goods, and unmeasured quality changes 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.

The CPI overstates inflation by about 1 percentage

point per year.


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The GDP Deflator versus the Consumer

Price Index

Economists and policymakers monitor

both the GDP deflator and the consumer

price index to gauge how quickly prices

are rising.

There are two important differences

between the indexes that can causethem to diverge.


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Price Index The GDP deflator reflects the prices of all

goods and services produced

domestically, whereas...

the consumer price index reflects the

prices of all goods and services bought

by consumers.


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Price Index The consumer price index compares the price of a

fixed basketof goods and services to the price of

the basket in the base year (only occasionally doesthe BLS change the basket)...

whereas the GDP deflator compares the price of

currently producedgoods and services to the price

of the same goods and services in the base year.


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1965

Percent

per Year15

10

5

01970 1975 1980 1985 1990 1995 2000

CPI

Two Measures of Inflation

GDP deflator


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Dollar Figures

from Different TimesPrice indexes are used to correct

for the effects of inflation when

comparing dollar figures from

different times.


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Dollar Figures

from Different Times Do the following to convert (inflate) Babe

Ruths wages in 1931 to dollars in 1995:

1931inlevelPrice

1999inlevelPriceSalary=Salary 19311999


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Dollar Figures from Different Times Do the following to convert (inflate) Babe

Ruths wages in 1931 to dollars in 1995:

$873,684=

15.2

166$80,000=

1931inlevelPrice

1999inlevelPriceSalary=Salary 19311999


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The Most Popular Movies of All Time, Inflation

AdjustedFilm

Year ofRelease

Total domestic grossin millions of 1999 dollars

1. Gone with the Wind 1939 $920

2. Star Wars 1977 798

3. The Sound of Music 1965 638

4. Titanic 1997 601

5. E.T.The Extra Terrestrial 1982 601

6. The Ten Commandments 1956 587

7. Jaws 1975 574

8. Doctor Zhivago 1965 543

9. The Jungle Book 1967 485

10. Snow White and the Seven Dwarfs 1937 476


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IndexationWhen some dollar amount is

automatically corrected for inflation bylaw or contract the amount is said to

be indexed for inflation.


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Real and Nominal Interest RatesInterest represents a payment inthe future for a transfer of

money in the past.


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Real and Nominal Interest Rates The nominal interest rate is the interest

rate 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 inflation.

Real interest rate = (Nominal interest rate Inflation rate)


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Real and Nominal Interest Rates You borrowed $1,000 for one year.

Nominal interest rate was 15%.

During the year inflation was 10%.

Real interest rate = Nominal interest rate Inflation

=15% - 10% = 5%


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1965

Interest Rates(percent per

year)

15

10

5

0

-51970 1975 1980 1985 1990 1995 1998

Nominalinterest rate

Real interest rate

Real and Nominal Interest Rates


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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 overalllevel 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

measure of the cost of living for the

following three reasons: substitution bias,

the introduction of new goods, andunmeasured changes in quality.

Because of measurement problems, the CPI

overstates annual inflation by about 1percentage point.


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Summary The GDP deflator differs from the CPI

because it includes goods and services

produced rather than goods and services

consumed.

In addition, the CPI uses a fixed basket of

goods, while the GDP deflator

automatically changes the group of goodsand services over time as the composition

of GDP changes.


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Summary Dollar figures from different points in

time do not represent a valid comparison

of purchasing power.

Various laws and private contracts useprice indexes to correct for the effects of

inflation.

The real interest rate equals the nominalinterest rate minus the rate of inflation.


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Graphical

Review


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Whats in the CPIs Basket?Housing

Food/Beverages

Transportation

Medical Care

Apparel

Recreation

Other

Education andcommunication

40%

16%

17%

6%

5%6%

5% 5%


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Two Measures of Inflation

1965

Percent

per Year15

10

5

01970 1975 1980 1985 1990 1995 2000

CPI

GDP deflator


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1965

Interest Rates(percent per

year)

15

10

5

0

-51970 1975 1980 1985 1990 1995 1998

Nominalinterest rate

Real interest rate

Real and Nominal Interest Rates

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