the cpi and the cost of living

The CPI and the

Costof Living

Chapter

1CHAPTER OUTLINE

1. Explain what the Consumer Price Index (CPI) is and how it is calculated.

A. Reading the CPI NumbersB. Constructing the CPIC. The CPI Market BasketD.The Monthly Price SurveyE. Calculating the CPIF. Measuring Inflation and Deflation

2.Explain the limitations of the CPI and describe other measures of the price level.

A. Sources of Bias in the CPI1. New Goods Bias2. Quality Change Bias3. Commodity Substitution Bias4. Outlet Substitution Bias

B. The Magnitude of the BiasC. Two Consequences of the CPI Bias

1. Distortion of Private Contracts2. Increases in Government Outlays and Decreases in Taxes

D.Alternative Measures of the Price Level and Inflation Rate1. GDP Price Index2. Personal Consumption Expenditures (PCE) Price Index3. PCE Price Index Excluding Food and Energy

3.Adjust money values for inflation and calculate real wage rates and real interest rates.

A. Dollars and Cents at Different DatesB. Nominal and Real Values in MacroeconomicsC. Nominal GDP and Real GDPD.Nominal Wage Rate and Real Wage RateE. Nominal Interest Rate and Real Interest Rate

© 2015 Pearson Education, Inc.

266 Part 4 . MONITORING THE MACROECONOMY

What’s New in this Edition?Chapter 16 features updated data throughout and a new example for the Eye on the Box Office.

Where We AreIn Chapter 16, we explain what the Consumer Price Index (CPI) is and how it is calculated. We examine the limitations of the CPI as a measure of the cost of living. Next we look at alternative measures of the price level: the GDP price index, the PCE price in-dex, and the PCE price index excluding food and en-ergy. Finally we show how to adjust money values for inflation and calculate real wage rates and real interest rates.

Where We’ve BeenThe previous chapters described other basic mea-surements in macroeconomics—GDP and the labor market. Chapter 21 described the basic facts about the macroeconomy, such as how U.S. GDP has changed over time. Chapter 22 discussed employ-ment and unemployment and their changes over time.

Where We’re GoingThis chapter is essentially the last descriptive chap-ter. The next chapter starts the more theoretical part of the course. It examines the economy at full employment and discusses potential GDP and the natural unemployment rate.

IN THE CLASSROOM

Class Time NeededThe material in this chapter can be covered in one and a half to two class sessions. If you mention current events, such as the current in-flation rate, be sure to use the most current data available. You can check the Foundations or BLS Web site for these data.

An estimate of the time per checklist topic is:

16.1 The Consumer Price Index—30 to 45 minutes

16.2 The CPI and Other Price Level Measures—30 to 40 minutes

16.3 Nominal and Real Values—20 to 30 minutes


Chapter 16 . The CPI and the Cost of Living 267

Class Activities: Ask your students to match their expenditure patterns with those in the CPI basket displayed below. The table presents a list of items and what the Bureau of Labor Statistics reported as the average expenditure in a typical market basket of goods for 2013. List the categories and leave the percentages blank. Next, ask your students to write down their own personal percentage ex-penditures for the list you have provided them. Remind them that they should make estimates of what percentage each item represents in terms of their an-nual income. After a couple of minutes or so, reveal the actual weights that the BLS reported for 2013. Then ask your students to place a check mark against each expenditure category in which he or she observes a substantial difference in relative weightings. In addition, you also can ask them to reveal if there are any items that are on their personal list that did not make it on the BLS list. The point of this activity is to demonstrate that although the CPI is a statistically sound measure of the average change in the cost of a bundle of goods; it does not measure each and every individual person’s average change in cost.

Indeed, there is at least one item on this list that has a markedly different weight of importance than the figure that your students assigned to it. That item is edu-cation. Many students who are working their way through college are probably also paying their own tuition. It is likely that the percentage in this category is much higher than the BLS reported figure.

This activity can be combined with the Eye on Your Life discussed at the end of this chapter.

Item2013 Weight in CPI Market

Basket(percent)

Housing 40.9

Transportation 17.2

Food and beverages 15.2

Medical care 7.2

Education and communica-tion

6.7

Recreation 6.0

Apparel 3.6

Other goods and services 3.4



CHAPTER LECTURE

16.1 The Consumer Price IndexThe Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed market basket of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics (BLS).

Reading the CPI Numbers The CPI is defined to equal 100 for a period called the reference base pe-

riod. The current reference base period is 1982-1984, so the average CPI during that period was 100.

In May 2013, the CPI was 232.9. Thus, since 1982-84, prices have increased by 132.9 percent to May 2013.

Constructing the CPI The BLS conducts a survey of consumers (the Consumer Expenditure Survey)

to determine the average market basket of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the market basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost in the base period, or

For example, suppose the initial survey shows that the CPI market basket is 2 books and 20 coffees. The initial base period prices and quantities are in the first table below. In this base period, say 2013, the cost of the CPI market basket is $100.

Next suppose that the BLS survey taken one month in 2014 reveals that the price of a book is $35 and the price of a coffee is $3. These 2014 prices and the initial base period quantities are in the table to the right. In this period the cost of the CPI basket is $130.

Using these data, the CPI equals ($130 $100) 100, or 130. So between the base period and the current period, the CPI has risen by 30 percent.

Lecture Launcher: Students might get the wrong idea in believing that the BLS blindly measures exactly the same quanti-ties of goods from year to year. While true in general, it does smooth over some im-


Item Quan-tity

Price

Cost(dollars)

Books

2 $30 $60

Cof-fee

20 $2 $40

Bas-ket

$100

Item Quan-tity

Price

Cost(dollars)

Books

2 $35 $70

Cof-fee

20 $3 $60

Bas-ket

$130


portant details that are worth mentioning. One of them you could use for illustra-tion in class is the treatment of college textbooks. Below is an example:College textbooks have a relatively high number of replacements (which occur when the book that has been followed is no longer sold in the outlet) and in many cases the replacement is not comparable to its predecessor. For example, over the one year time period from June 1998 to May 1999, the CPI priced a to-tal of 948 quotes for the College textbook category. From this full year of quotes, 113 quotes (12 pe8rcent) were replacements. Of the 113 replacements, 40 quotes (35 percent) were deemed to be either comparable or able to be quality adjusted, and thus could be used in the CPI. The remaining 73 quotes (65 per-cent) were not comparable, and were deemed to be eligible for other processing where estimated price change is used based on price movement of comparable replacement items. Ultimately, this meant that 1 out of every 13 priced quotes in this item category over the course of a year were non-comparable replacements. These figures led to the conclusion that College textbooks more than qualified as a candidate for hedonic regression analysis.1

While you probably won’t want to get into the business of what a hedonic regres-sion analysis is, you might still find the passage useful in demonstrating that the BLS goes to great pains to try to get the CPI right.1Reese, Mike, “Hedonic Quality Adjustment Methods for College Textbook in the U.S. CPI.”

Measuring Inflation and Deflation The inflation rate is the percentage change in the price level from one year

to the next. In a formula: Inflation rate =

Deflation is when the price level is falling and the inflation rate is nega-tive.

Land Mine: Be careful to explain the difference between calculating the CPI and calculating the inflation rate. Students easily confuse the two!

16.2 The CPI and Other Price Level MeasuresThe CPI is a cost of living index, which is a measure of the change in the amount of money that people need to spend to achieve a given standard of living. However, the CPI is not a perfect measure of the cost of living because it does not try to mea-sure all the changes in the cost of living and the components that are measured are not always measured accurately.

Sources of Bias in the CPI The CPI has four biases that lead it to overstate the inflation rate. The biases

are:

New Goods Bias: New goods are often more expensive than the goods they replace.



Quality Change Bias: Sometimes price increases reflect quality improve-ments (safer cars, improved health care) and should not be counted as part of inflation.

Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases.

Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently.

The Magnitude and Consequences of the Bias The Boskin Commission in 1996 estimated the bias overstates the inflation

rate by about 1.1 percentage points a year. Many contracts and payments are indexed to the CPI. If the CPI is biased,

then these contracts are distorted because they incorrectly account for infla-tion.

Many government outlays, such as Social Security payments, are linked to the CPI. If the CPI is biased upward, then government outlays increase more than what is required to offset inflation. Taxes are also indexed to the CPI so that the incomes for which tax rates rise are adjusted to take account of infla-tion. The upward bias means that adjustments are biased upward so that the government collects less tax revenues.

To reduce the bias, the BLS has decided to undertake consumer spending surveys more frequently.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is hard to adjust Social Security payments for the bias, so the current plan is to reduce the measurement bias in the CPI, for instance by revising the basket more frequently to reflect new goods and substitution changes.

Alternative Measures of the Price Level and Inflation Rate The GDP price index (also called the GDP deflator) is an average of the cur-

rent prices of all the goods and services in GDP expressed as a percentage of base-year prices. The GDP price index includes prices of all the goods and services in GDP: consumption expenditure, investment, government expendi-ture, exports, and imports. The GDP price index is broader than the CPI, but is not perfect because it still suffers from the CPI’s biases since the CPI is used to help construct real GDP.

The PCE price index is an average of the current prices of the goods and services in the consumption expenditure part of GDP expressed as a percent-age of base-year prices.

The percentage change in the PCE price index excluding food and energy measures the core inflation rate. Food and energy prices fluctuate much more than other prices and their changes can obscure the underlying trends in prices.

Students (and the media) often don’t understand why core inflation is a use-ful measurement and assume it is a way for the government or economists to trick people into thinking inflation is not as high by removing food and en-ergy prices, which obviously do play a role in people’s expenditures. It is im-



portant to identify that food and energy prices can be extremely volatile, es-pecially as a function of weather and global politics. Not only does this volatility complicate the analysis of other price changes, but from a policy perspective core inflation measurements may serve as a better guide than overall inflation. Food and energy price changes that are the result of changes in weather and global politics are largely outside of the influence of policies. Therefore, it may make sense to ignore them and focus on core infla-tion when designing policies, since it’s that underlying inflation that may be a reflection of the functioning of the economy and economic policies, as op-posed to external factors which cannot be controlled. This is why policymak-ers (especially the Federal Reserve) tend to focus more on core inflation when designing policies.

Over time, the CPI and PCE indices move up and down in similar ways, but the previously discussed biases cause the CPI to rise slightly more rapidly than the PCE indices.

16.3 Nominal and Real Values

Dollars and Cents at Different Dates To compare dollar amounts at different dates, we need to know the CPI at

those dates. To convert the price of a good in past dollars to its price in cur-

rent dollars, multiply the earlier price by

Nominal and Real Values in MacroeconomicsThe difference between nominal and real variables is important in macroeconomics. In macroeconomics, we generally use the GDP deflator rather than the CPI as our measure of the price level because we are dealing with economy totals, of which consumer spending is just one part.

Real values seem to cause students confusion. Reiterate why we calculate real val-ues and that the calculation of the real wage is just like the calculation of real GDP, only using a different set of variables. It may be helpful to show the real calculations side-by-side by writing out (real wage) = (nominal wage) (CPI) and real GDP = (nominal GDP) (GDP deflator). In other words, show your students the same gen-eral formula—real variable equals nominal variable divided by the price level—ap-plies to all real variables except, of course, the real interest rate.

Nominal GDP and Real GDP

Real GDP =

Nominal Wage Rate and Real Wage Rate The nominal wage rate is the average hourly wage rate measured in cur-

rent dollars and the real wage rate is the average hourly wage rate mea-sured in dollars of a given reference base year.

The real wage rate =



The real wage rate is the quantity of goods and services that an hour’s work can buy.

Between 1981 and 2011 the nominal wage rate more than doubled but the real wage rate stayed roughly constant because the increase in the nominal wage rate just kept up with inflation.

Ask students to think about whether it is the real wage or the nominal wage that matters to them. You may want to use a numerical example to illustrate how an in-crease in prices without an increase in the nominal wage will reduce the amount of goods and services a student can buy. This procedure will help to cement the idea of the real wage.

Nominal Interest Rate and Real Interest Rate The nominal interest rate is the percentage return on a loan calculated by

using dollars. The real interest rate is the percentage return on a loan cal-culated by using purchasing power; it’s the nominal interest rate adjusted for the effects of inflation. Real interest rate = Nominal interest rate Inflation rate. When the inflation rate was high, during the 1970s and early 1980s, the

gap between the real interest rate and the nominal interest rate was large. The real interest rate was negative in the mid-to-late 1970s and very high in the early 1980s, but has shown no real upward or downward trend since 1971.

To be sure that your students understand that the real interest rate is similar to the real wage rate and real GDP insofar as it’s in real terms, mention that the calcula-tion of the real interest rate also “deflates” the nominal interest rate. However, be-cause the numbers are already percentages, we must subtract the percentage change in prices (the inflation rate) rather than divide by the price level.



USING EYE ON THE PAST

700 Years of Inflation and Deflation

Richard Gosselin once had a historian friend ask if he could provide him with inflation data for the past 200 years. Richard asked his friend why he wanted it and he explained that it was for a book he was writing and he wanted to include comparisons of the cost of living of the colonial period to that of today. Richard told him that he would see what he could do. After speaking with someone at the Federal Re-serve Bank in Dallas, Richard had the answer. When he handed his colleague the figures, he explained to him that the numbers might not be very useful for comparing costs of living between such disparate time periods such as the colonial period and today. When he asked why, Richard responded by saying that it is difficult to measure changes in the cost of living between two time periods that in all like-lihood do not even share 10 percent of the same goods in what would be a typical market basket of an average household. Richard thought he got the point until he noticed that he included the figures in his book anyway and gave him credit in the acknowledgement! No good deed goes unpunished. The point of this little story is that we have to be very careful with inflation data that is measured over long periods of time. It’s not that the people who computed the figures or gathered the data made a mistake. The problem is making standard compar-isons of market baskets of goods where no meaningful comparison can be made.

The Nominal and Real Wage Rates of Presidents of theUnited States

As the section suggests, it is not always such a straightforward exer-cise to calculate real wage rates. Jobs change in terms of responsibil-ity and the amount of physical and mental effort that must go into them. As a take-home exercise, you can ask your students to come up with a list of five professions whose responsibilities have not changed very much and five that have undergone marked change. Then ask them to research the salary of these professions going back 50 years and calculate the real wages at decade intervals. Invite them to share the results with the rest of their classmates at the next regularly scheduled class meeting. This assignment can provide for a lively dis-cussion as some students will no doubt point to job characteristic dif-ferences that their classmates had not thought about. It leads to the even thornier issue of coming up with valuations of increased ameni-ties on the job.



USING EYE ON THE U.S. ECONOMY

Deflating the GDP Balloon

This segment might be best used if you introduce it before you actu-ally present the discussion about the GDP price index. The GDP price index is one of these topics for which the underlying economic forces at work is often difficult to explain. The balloon metaphor is an excel-lent way to appeal to students’ intuitions, especially for visual learn-ers.

USING EYE ON BOX OFFICE HITS

Which Movie Really Was the Biggest Box Office Hit?

This Eye discusses how a price index can be used to compare the real value of money between time periods. If your students are anything like me, they have heard countless times the reminiscing of elderly relatives about how things were so much better when they were kids. You will, no doubt, have an ample supply of students who will tell you that their elders brag about the nickel Coca-Cola they enjoyed or the 50-cent movies they went to. Advise your students that when people often complain about the rising price of something they are nearly al-ways speaking of nominal prices, not real prices. So, in today’s dol-lars, how much was that famous nickel Coca-Cola we’ve heard so much about? If we use 1939 as the starting year, a $.05 Coca-Cola would be the equivalent of paying $.84 in 2013 – which for a 12oz can purchased from a grocery store, would be a bit on the high side (espe-cially if considering the per unit price of purchasing in bulk). What about a $.50 movie? A $.50 cent movie in 1939 (the year Gone with the Wind was first released), would be $8.40 in 2013 – which is about the same as the 2013 average ticket price. You might want to stress the opportunity cost element here. That is, if the price of a particular good is rising at a slower rate than other the prices of other goods, then the opportunity cost of acquiring that item has actually fallen. Perhaps the good ‘ole days weren’t as good as we’ve heard!

USING EYE ON YOUR LIFE

A Student’s CPI

This Eye discusses how the CPI is not necessarily a reflection of how all consumers experience inflation. You can integrate the class activity previously suggested with this Eye. How does their personal market basket compare to that of the average American household? How does



it compare to the student’s basket of goods created in this Eye? How might the market basket of a group near the opposite end of the age scale – senior citizens – compare to the student market basket and the average market basket used by the CPI? Given that college students and seniors may rely on more fixed incomes than most groups (finan-cial aid and Social Security, respectively), why do these price trends pose more of a problem for these groups? Why might using CPI mea-surements for different groups (a student CPI, a senior CPI, etc) in-stead of just the general CPI be useful for targeted income assistance programs like financial aid and Social Security? How does the fact that the CPI tends to overstate the actual rate of inflation complicate this analysis?


Item

3001 3002

Quan-

tity

Price Quantity Price

Games 10 $30 5 $35Time

Travel 0 10 $4,000


ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions Checkpoint 16.1 The Consumer Price Index1 A Consumer Expenditure Survey in the city of Firestorm shows

that people consume only firecrackers and bandages. In 2010, the year of the survey and also the reference base year, the aver-age household spent $100 on firecrackers and $10 on bandages. The price of a firecracker in 2000 was $2, and the price of ban-dages was $1 a pack. In the current year, 2011, the price of a firecracker is $3 and the price of bandages is $1.25 a pack. Cal-culate:

1a. The CPI basket.1b. The percentage of a household's budget spent on firecrackers in

the base year.1c. The CPI in 2011.1d. The inflation rate in 2011.

2. Assume a two-good world in which the market basket is 10 units of good A and 2 units of good B. Good A costs $4 and good B costs $1 in year 1. Furthermore, assume that in year 2 the prices rise to $5 and $2, respectively. Calculate the inflation rate in year 2. Will the choice of base year affect your answer?

Checkpoint 16.2 The CPI and Other Price Level Measures3. In Virtual Reality, time travel be-

came possible only in 3002. Econo-mists in the Statistics Bureau de-cided to conduct a Consumer Ex-penditure Survey in both 3001 and 3002 to check the substitution bias of the CPI. The table shows the re-sults of the survey. It shows the items that consumers buy and their prices. The Statistics Bureau fixes the reference base year as 3001 and asks you to:

3a. Calculate the CPI in 3002 using the 3001 CPI basket.3b. Calculate the CPI in 3002 using the 3002 CPI basket. I3c. Explain whether there is any substitution bias in the CPI that

uses the 3001 basket.4. List the sources of bias in the CPI that are discussed in the text

and give a brief explanation of each.

5. Identify the consequences of the CPI bias mentioned in the text and discuss each.

Answers Checkpoint 16.1 The Consumer Price Index1a. The CPI basket is the quantities bought during the Expenditure

Survey year, 2010. Households spend $100 on firecrackers at $2



a firecracker so the quantity of firecrackers bought was 50. Households spend $10 on bandages at $1 a pack so the quantity of bandages bought was 10 packs. The CPI basket is 50 firecrack-ers and 10 packs of bandages.

1b. In the reference base year, expenditure on firecrackers was $100 and expenditure on bandages was $10, so the household budget was $110. Expenditure on firecrackers was 90.9 percent of the household budget: ($100 $110) 100 = 90.9 percent.

1c. To calculate the CPI in 2011, find the cost of the CPI basket in 2011 and 2010. In 2010, the CPI basket costs $110 ($100 for fire-crackers and $10 for bandages). In 2011, the CPI basket costs $150 for firecrackers (50 $3 a firecracker) plus $12.50 (10 packs of bandages $1.25 a pack), which is $162.50. The CPI in 2011 equals ($162.50 $110) 100 = 147.7.

1d. The inflation rate in 2011 is [(147.7 100.0) 100.0] 100 = 47.7 percent.

2. The cost of the basket in year 2 is $50 + $4 = $54. The cost of the basket in year 1, the base year is $40 + $2 = $42. The CPI for year 2 is $54 $42 100 = 128.5. The inflation rate in year 2 is [(128.5 100.0) ÷ 100.0] 100.0 = 28.5 percent. It doesn’t make any difference which year is chosen as the base year. We get the same rate of inflation for year 2.

Checkpoint 16.2 The CPI and Other Price Level Measures3a. Using the 3001 CPI basket, the cost of the basket in 3001 is $300

and the cost of the basket in 3002 is $350. (Note that time travel does not enter into the cost in 3002 because it is not in the CPI basket.) The CPI in 3002 is ($350 ÷$300) 100 = 116.7.

3b. Using the 3002 CPI basket, the cost of the basket in 3001 is $150. (Note that time travel does not affect the cost of this basket because its price is undefined in 3001.) The cost of 3002 CPI bas-ket in 3002 is $40,175. (10 time travels $4,000 + 5 games $35). The CPI in 3002 is ($40,175 ÷ $150) 100 = 26,783.3.

3c. There is not any commodity substitution bias but there is a huge new goods bias. In particular, the new good, time travel, is sig-nificantly more expensive than the good it is partially replacing, games. Some of the price increase caused by the introduction of time travel is not pure inflation but instead represents the higher quality of time travel as entertainment compared to games.

4. There are four biases:New goods bias — new goods replace old goods all the time. The problem rests in how to measure changes in the prices of goods when the goods themselves might no longer be directly compara-ble.Quality change bias — difficult to account for changes in the quality of a good across time. If a good is really better and costs more does it make sense to conclude that all the increase is at-tributable to inflation? Filtering out the two is not an easy job.



Commodity substitution bias — because the CPI is based on a fixed basket, it does not take into account that consumers can and will make substitutions away from goods whose prices rise and toward relatively cheaper substitutes. If a consumer reduces his or her consumption of a particular good whose price has risen, his or her total expenditure on that item may not be any greater than before.Outlet substitution bias — the fact that consumers substitute from shopping at full service retail stores to discount stores when prices rise. This substitution is not taken into account when com-puting the CPI, which places an upward bias in the CPI measure-ment.

5. One consequence of the CPI bias is that it distorts contracts. Many private contracts use the CPI as a cost of living adjustment measure. If the figure is biased upward by one percentage point, the bias will lead employers to pay more for labor than the in-crease in the true CPI would suggest. A second consequence is increases in government outlays. Several federal government out-lays tie benefits to the CPI. These include Social Security recipi-ents, food stamps, and pensions paid to former military personnel and civil servants. Over many decades these outlays can add up to a trillion dollars. The third consequence is decreases in tax revenues. For some taxes, the levels of income at which higher tax rates are applied are linked to the CPI. Because the CPI is up-ward biased, these income levels rise more rapidly than does the cost of living and so the amount of tax revenue collected by the government is lower than would otherwise be the case.


the cpi and the cost of living

Business

althoughthe cpi

cpi bias1

cpi numbersb

consumer price index30

consumer price indexcpi

gdp price index2

cpi market basketd

price level measures30