The CPI and the Cost of Living

CHAPTER7Eye Ons

Consumer price index Nominal interest rateCost of living index Nominal wage rateReference base period Real interest rate

Real wage rateInflation rate

DEFINITION

CPI – Consumer Price Index

1. Measure of the AVERAGE

2. of prices PAID

3. by URBAN consumers

4. for a FIXED MARKET BASKET

5. of CONSUMPTION goods and services

• CPI = 100, in the Reference Base Period

• Current Reference Base Period is 1982-1984

WHY DO WE CARE

CPI – Consumer Price Index

• Jul 2007, CPI=208.3 • Average of prices paid by urban consumers for fixed market

basket of goods

• Was 108.3% in Jul 2007 than in 1982-1984

• Aug 2007, CPI=207.9 • Average of prices paid by urban consumers for fixed market

basket of goods

• Was 107.9% in Jul 2007 than in 1982-1984

• Comparing July 2007 to August 2007 tells us • Average of prices paid by urban consumers for fixed market

basket of goods

• Decreased by 0.4 from Jul to Aug 2007

CONSTRUCTING CPI

1. SELECT the MARKET BASKET1. Weights of goods = urban household budget

2. CPI IS calculated monthly, Basket IS NOT updated monthly

3. Current basket (2007) is based on 2005 survey

CONSTRUCTING CPI

2. Conduct Monthly Price Survey1. Prices recorded

• 80,000 goods and services

• In 30 metropolitan areas

2. Products must be exactly the same.

• Thus, specific statistics must be recorded

• Quality

• Size

• Weight

• Packaging

• And more

CONSTRUCTING CPI

2. Calculating CPI – STEP 1

CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

CONSTRUCTING CPI

2. Calculating CPI – STEP 2

CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

CONSTRUCTING CPI

2. Calculating CPI – STEP 3

CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

For 2005, the CPI is: = 100$50

$50x 100

For 2008, the CPI is: = 140$70

$50x 100

6.1 THE CONSUMER PRICE INDEX

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 =

These data show that inflation became a persistent problem only after 1900.

During the preceding 600 years, inflation was almost unknown.

700 Years of Inflation and Deflation

There was a burst of inflation during the sixteenth century after Europeans discovered gold in America, but this inflation was less than 2 percent a year.

Inflation eventually subsided.

The Industrial Revolution was a temporary burst of inflation.

The graph provides dramatic evidence that inflation took off during the last century.

700 Years of Inflation and Deflation

6.1 THE CONSUMER PRICE INDEX

Price level has increased every year. Inflation = High in 1980’s, Low in 1990’s

CPI and the COST OF LIVING

Cost of Living = •the amount of $$$

•a person must spend

•to achieve a certain standard of living

CPI DOES NOT measure cost of living

1.Does not measure ALL components of living

• Severe winter = increase in natural gas purchase

• price is caught but not quantity – basket is fixed

2.Components of CPI are not always ACCURATE

• Thus, it would be a biased measure of changes in cost of living

CPI and the COST OF LIVING

BIAS in the CPI

•New goods bias• New goods perform better but cost more [cost=quality]

• Upward bias into the CPI and inflation rate

•Quality change bias• Better products cost more [price due to quality IS

NOT inflation, but would be counted as such]• Upward bias into the CPI and inflation rate

CPI and the COST OF LIVING

BIAS in the CPI

•Commodity substitution bias• $ of beef rises faster than $ of chicken = you buy more chicken

and less beef• CPI Basket is fixed and does allow for substitutions and says the price of

meat has increased

•Outlet substitution bias• Prices rise…people use discount stores more often

• CPI Basket is fixed and does allow for substitutions and says the prices has decreased

CPI

EFFECTS of the BIAS in the CPI

•Overstates inflation• Estimated to overstate inflation by 1.1%

•Distorts Private Contracts• Union contracts

•Increases Government Outlays • 48 Million Social security benefits• 22 Million Food stamps• 4 Million Pensions of Retired Personnel • 27 Million School lunch budgets

ALTERNATIVES to CPI

GDP Deflator 1. Average of

2. current prices of

3. all the goods and services included in GDP

4. expressed as a percentage of base-year prices.

GDP deflator = (Nominal GDP Real GDP) 100.

• Price level is measured by GDP deflator

• Inflation measured by % change in GDP deflator

GDP Deflator vs CPI

Prices of ALL goods and services

Weights items using CURRENT and PAST quantities

Prices of CONSUMPTION goods and services

Weights items using PAST quantities (from surveys)

GDP Deflator CPI

In theory GDP Deflator is NOT subject to CPI biases. [includes new goods, quality changes, and allow for substitutions]

In reality: the commerce department does not measure physical quantities of produced items. It divides expenditures by price indexes – one of which is CPI.

ALTERNATIVES to CPI

PCE Deflator1. Average of

2. current prices of

3. all the goods and services included in consumption expenditure component of GDP

4. expressed as a percentage of base-year prices.

• Overcomes the biases to some degree

• Is a measure of cost of living

ALTERNATIVES to CPI

CPI is highest PCE lies between CPI

and GDP deflator

Deflating the GDP Balloon

Part of the increase in nominal GDP reflects increased production and part reflects rising prices.You can think of GDP as a balloon that is blown up by growing production and rising prices.

Deflating the GDP Balloon

The GDP deflator lets the inflation air—the contribution of rising prices—out of the nominal GDP balloon so that we can see what has happened to real GDP.

Deflating the GDP Balloon

The figure shows the increase in nominal GDP from 1980 to 2007. With the inflation air removed, you can see by how much real GDP grew.

ANOTHER USE of CPI

Prices on Different Dates

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

Price of stamp in 2007 dollars =

= 2 cents x

207.2

10= 41 cents

Price of stamp in 1907 dollars xCPI in 2007

CPI in 1907

NOMINAL vs REAL VALUES

1. Nominal vs Real GDP Learned in Chapter 5

2. Nominal vs Real Wage Rate - Average hourly wage rate measured in

current dollars dollars of a given reference base year

3. Nominal vs Real Interest Rate - Percentage return on a loan expressed in dollars calculated by purchasing power – nominal interest rate

adjusted for the effects of inflation

Nominal wage rate in 2006CPI in 2006

x 100Real wage rate in 2006 =

Real interest rate = Nominal interest rate – Inflation rate.

NOMINAL vs REAL WAGE RATE EXAMPLE

Real wage rate in 2006 = = $8.23 $16.73

201.6x 100

Nominal wage rate in 2006

CPI in 2006x 100Real wage rate in 2006 =

The $8.23 amount is in 19821984 dollars.

• How to find the REAL WAGE RATE • given that years Nominal wage rate

6.3 NOMINAL AND REAL VALUES

Figure 6.4 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.

6.3 NOMINAL AND REAL VALUES

Figure 6.5 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.

Real interest rate = Nominal interest rate – Inflation rate.

The figure shows the cost of a first-class letter since 1907.

The green line is the nominal price—the actual price of a stamp in the dollars (cents) of the year in question.

The Nominal and Real Price of a First-Class Letter

The red line is the real price—the price in terms ofthe 2007 dollar.

The nominal price has gradually increased, but the real price has fluctuated—sometimes rising and sometimes falling.

The Nominal and Real Price of a First-Class Letter

The highest real price, 45 cents, occurred in 1933 and the lowest real price, 19 cents, occurred in 1920.

The Nominal and Real Price of a First-Class Letter

Who earned more, George W. Bush in 2005 or George Washington in 1789?

George Washington was paid $25,000 in 1789.

George W. Bush was paid $400,000 in 2005.

The Nominal and Real Wage Rates of Presidents of the United States

The Nominal and Real Wage Rates of Presidents of the United States

Who earned more: Barack Obama in 2008 or George Washington in 1789?

George Washington was paid $25,000 in 1789 (on green line), but in 2005 dollars, his real pay was $521,000 (on red line).

Barack Obama was paid $400,000 in 2009.

The Nominal and Real Wage Rates of Presidents of the United States

The White House is more comfortable and presidential travel arrangements today are a breeze compared to earlier times.

So adding in the perks of the job, Barack Obama doesn’t get such a raw deal.

FORMULAS

CPI in current year CPI in previous yearCPI in previous year

x 100Inflation rate =

CPI =Cost of CPI basket at current period prices

Cost of CPI basket at base period pricesx 100

GDP deflator = (Nominal GDP Real GDP) 100.

Price of stamp in 2007 dollars =Price of stamp in 1907 dollars

xCPI in 2007

CPI in 1907

Nominal wage rate in 2006

CPI in 2006x 100Real wage rate in 2006 =

Real interest rate = Nominal interest rate – Inflation rate.

Suppose you have a student loan of $80,000.

Suppose that the CPI rises by 3 percent a year each year from now (2008) through 2028.

Also suppose that the nominal interest rate on your loan is fixed at 5 percent a year.

How much will a $100 repayment cost you in 2008 dollars, when you start to pay off your loan in 2018?

How much will a $100 repayment cost you in 2008 dollars, when you make your final payment in 2028?

What is the real interest rate that you will have paid?

Using the CPI

You can answer all these questions.

Set the CPI in 2008 equal to 100.

With the CPI rising at a rate of 3 percent per year, the CPI in 2018 will be 134.

A $100 payment in 2018 is equivalent to a $74 payment in 2008. ($100 ÷ 134) x 100 = $74.

The CPI in 2028 will be 181.

So a payment of $100 in 2028 is equivalent to a payment of $55 in 2008.

Using the CPI

The further in the future a payment is made, the less is your $100 payment in today’s dollars.

Your real interest rate is the 5 percent a year nominal interest rate minus the 3 percent a year inflation rate.

Your real interest rate is 2 percent per year.

Using the CPI