lecture 18 (cpi cost of living).pdf

The CPI and the

Cost of LivingCHAPTER22

22.1 THE CONSUMER PRICE INDEX

Consumer Price Index (CPI) is a measure of the

average of the prices paid by consumers for a fixed

market basket of consumer goods and services.

The Malaysia’s Department of Statistics calculates the

CPI every month.

We can use these numbers to compare what a fixed

basket of goods costs this month with what it cost in

some previous month.


Reading the CPI Numbers

The CPI is defined to equal 100 for a period called the

reference base period.

Reference base period is a period for which the CPI

is defined to equal 100. Currently, the reference base

period in Malaysia is 2005.


In 2006, the CPI in Malaysia was 103.6.

The average of the prices paid by consumers for a

fixed market basket of consumer goods and

services was 3.6 percent higher in 2006 than it was

in the base year 2005.


Constructing the CPI

Three stages:

• Selecting the CPI basket

• Conducting the monthly price survey

• Calculating the CPI


The CPI Basket

Make the relative importance of the items in the CPI

basket the same as in the budget of an average

household.

The CPI is calculated each month, but the CPI basket is

not updated each month.

The current CPI basket in Malaysia in 2007 is based on

information obtained from the Household Expenditure

Survey conducted during 2004/2005.


CPI Basket Weights

Food & non-alcoholic beverages 31.4%

Housing, water, electricity, gas & other fuel 21.4%

Transport 15.9%

Communication 5.1%

Recreation 4.6%

Furnishing & household equipment & maintenance 4.3%

Clothing & footwear 3.1%

Restaurants & hotels 3.0%

Education 1.9%

Alcoholic beverages & tobacco 1.9%

Health 1.4%

The CPI Basket in Malaysia and its weights


Figure 22.1 shows the CPI basket in US.

This shopping cart is filled with the items that an average

household buys.


Calculating the CPI

The CPI calculation has three steps:

• Find the cost of the CPI basket at base period

prices.

• Find the cost of the CPI basket at current period

prices.

• Calculate the CPI for the base period and the

current period.

Table 22.1 on the next slide shows a simplified CPI

calculation in which we assume a base period of 2005.


CPI =Cost of CPI basket at current period prices

Cost of CPI basket at base period pricesx 100

For 2005, the CPI is: = 100$50

$50x 100

For 2008, the CPI is: = 140$70

$50x 100


Measuring Inflation

Inflation rate is the percentage change in the price

level from one year to the next.

Inflation rate = = 16.7 percent140 120

120x 100

CPI in current year CPI in previous year

CPI in previous year

x 100Inflation rate =

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Cost of living index is a measure of changes in the

amount of money that people would need to spend to

achieve a given standard of living.

The CPI is not a perfect measure of the cost of living

because:

• It does not measure all the components of the cost

of living

• Some components are not measured exactly

So the CPI is possibly a biased measure.

Sources of Bias in the CPI

The potential sources of bias in the CPI are

• New goods bias

• Quality change bias

• Commodity substitution bias

• Outlet substitution bias


New Goods Bias

• New goods (computer) do a better job than the old

goods (typewritter) that they replace, but cost more

• The arrival of new goods puts an upward bias into

the CPI and its measure of the inflation rate.

Quality Change Bias

• Better cars and televisions cost more than the

versions they replace.

• A price rise that is a payment for improved quality

is not inflation but might get measured as inflation.


Commodity Substitution Bias

• If the price of beef rises faster than the price of

chicken, people buy more chicken and less beef.

• The CPI basket doesn’t change to allow for the

effects of substitution between goods.

Outlet Substitution Bias

• If prices rise more rapidly, people use discount

stores more frequently.

• The CPI basket doesn’t change to allow for the

effects of outlet substitution.


The Magnitude of the Bias

In US, the Boskin Commission estimated the bias to be 1.1 percentage points per year.

If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year.

To reduce the bias, the US Bureau of Labor Statistics (BLS) has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years.

When the BLS revises the CPI basket, the reference base period does not change.


Two Consequences of the CPI Bias

Two main consequences of the bias in the CPI are

• Distortion of private contracts

• Increases in government outlays and decreases in

taxes

Distortion of Private Contracts

Many wage contracts are linked to the CPI.

If the CPI is biased, these contracts might deliver an

outcome different from that intended by the parties.


Suppose that the UAW (United Auto Workers Union) and GM (General Motors Corp.) sign a 3 year wage deal: In the first year, the wage will be $30 an hour and will rise by the inflation rate in the next two years.

If the inflation rate is 5 percent a year, the wage rises to $31.50 an hour in the second year and $33.08 an hour in the third year.

But if the actual inflation rate is 2 percent a year, the intended wages in the second and third years are $30.90 an hour and $31.83 an hour.

The workers’ gain is GM’s loss. With thousands of workers, GM’s loss would be millions of dollars over the 3 years.


Increases in Government Outlays and Decreases in Taxes

Close to a third of federal government outlays are linked directly to the CPI.

The CPI is used to adjust

• 48 million Social Security benefit payments

• 22 million food stamp payments

• 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses

• the budget for 27 million school lunches


The CPI is used to adjust the income levels at which

higher tax rates apply.

Because tax rates on large incomes are higher than

those on small incomes as incomes rise, the burden of

taxes would rise relentlessly if these adjustments were

not made.

To the extent that the CPI is biased upward, the tax

adjustments over-compensate for rising prices and

decrease the amount paid in taxes.


Alternative Measures of the Price Level

Several alternative measures of the price level are

available.

Here we look at

• The GDP deflator

• The personal consumption expenditures deflator

(PCE deflator)


GDP Deflator

The GDP deflator is an average of current prices of all

the goods and services included in GDP expressed as a

percentage of base-year prices.

GDP deflator = (Nominal GDP Real GDP) 100.

The GDP deflator is a measure of the price level and

the percentage change in the GDP deflator is a

measure of the inflation rate.


Two key differences between the GDP deflator and the CPI

result in different estimates of the price level and inflation

rate.

1.The GDP deflator uses the prices of all the goods and

services in GDP whereas the CPI uses prices of

consumption goods and services in CPI basket.

2. The GDP deflator weights each item using

information about current as well as past quantities.

In contrast, the CPI weights each item using

information from a past consumer expenditure survey.


Because the GDP deflator uses information on current

year quantities, it includes new goods and quality

improvements and even allows for substitution effects of

both commodities and retail outlets.

So in principle, the GDP deflator is not subject to the

biases of the CPI.


Personal Consumption Expenditures (PCE) Deflator

The PCE deflator is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices.PCE deflator = (Nominal consumption expenditure in

GDP Real consumption expenditure in GDP) 100.

The PCE deflator has the same advantages as GDP deflator—it uses current information on quantities and to some degree overcomes the sources of bias in the CPI.


22.3 NOMINAL AND REAL VALUES

Ringgit and Cents at Different Dates

To compare ringgit amounts at different dates, we need to know the CPI at those dates.

Convert the price of a 2-cent stamp in 1907 into its 2007 equivalent:

Price of stamp in 2007 ringgit =

= 2 cents x207.2

10.0= 41 cents

Price of stamp in 1907 ringgit xCPI in 2007

CPI in 1907


Ringgit and Cents at Different Dates

To compare ringgit amounts at different dates, we need to know the CPI at those dates.

Convert the price of a 41 cent stamp in 2007 into its 1907 equivalent:

Price of stamp in 1907 ringgit =

= 41 cents x10.0

207.2= 2 cents

Price of stamp in 2007 xCPI in 1907

CPI in 2007ringgit


Nominal and Real Values in Macroeconomics

Macroeconomics makes a big issue of the distinction

between nominal values and real values:

• Nominal GDP and real GDP

• Nominal wage rate and real wage rate

• Nominal interest rate and real interest rate

We studied the distinction between and calculation of

nominal and real GDP in Chapter 21. Here, we’ll look at

the other two.


Nominal and Real Wage Rates

Nominal wage rate is the average hourly wage rate

measured in current dollars.

Real wage rate is the average hourly wage rate

measured in the dollars of a given reference base year.


Real wage rate in 2006 = =RM48.26 RM50

103.6x 100

To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100.

Nominal wage rate in 2006

CPI in 2006x 100Real wage rate in 2006 =

The RM48.26 amount is in 2005 ringgit.


Figure 22.4 shows

nominal and real wage

rates: 1982–2006.

The nominal wage rate

has increased every

year since 1982.

The real wage rate

decreased slightly from

1982 through the mid-

1990s, after which

increased slightly.


Nominal and Real Interest Rates

Nominal interest rate is the percentage return on a

loan expressed in ringgit.

oDeposit RM100 in saving account

oNominal interest rate is 5% per year

o Interest return is RM5

oEarn RM105


Nominal and Real Interest Rates

Real interest rate is the percentage return on a loan,

calculated by purchasing power—the nominal interest rate

adjusted for the effects of inflation.

o Deposit RM100 in saving account

o Nominal interest rate is 5%, earn RM105

o Price increase 3%, need RM103 to buy what RM100

would have bought (purchasing power has decreased)

o Actual or real interest earn is 5% minus 3%

Real interest rate = Nominal interest rate – Inflation rate.


Figure 22.5 shows real and nominal interest rates: 1967–2007.

The nominal interest rate increased during the high-inflation 1980s.

During the 1970s, the real interest rate became negative.

lecture 18 (cpi cost of living).pdf

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