Measuring the Cost of Living - Introduction to Macroeconomics - Lecture Slides, Slides for Introduction to Macroeconomics

Introduction to Macroeconomics

Description: This course discusses the important economic theories and concepts that facilitate understanding economic events and questions. Its main focus is on analyzing the behavior of important economic aggregates such as national income, unemployment, inflation, interest rates, exchange rates and economics growth. Key points of this lecture are: Measuring the Cost of Living, Consumer Price Index, Bureau of Labor Statistics, Compute the Inflation Rates, Compute the Basket's Cost, Compute the Inflation Rate, Inflation Rate, Consumer Price Index, Substitution Bias, Introduction of New Goods Show more
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24

Measuring the Cost

of Living

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The Cost of Living

• We need all sorts of things to live

• These things are typically not free

• So, what’s the cost of living the way we

actually live? That is, what’s the cost of buying

the things we buy?

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Why Do We Need to Know the Cost of Living?

• To see whether our incomes are keeping up

with the cost of living

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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.

• When the CPI rises, the typical family has to spend

more dollars to maintain the same standard of

living.

• The Bureau of Labor Statistics (BLS) reports the

CPI each month.

• It is used to monitor changes in the cost of living

over time.

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• http://research.stlouisfed.org/fred2/series/CPIAUCSL

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How the CPI Is Calculated [BLS]

• Fix the basket: figure out what’s in the “basket”

of goods that the typical consumer buys

• Find the prices paid by the typical consumer for

the goods in the “basket”

• Compute the basket’s cost

• Choose a base year and compute the CPI for all

years

• Compute the inflation rates for all years

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How the Consumer Price Index Is Calculated

Fix the basket: determine what “basket” of

goods the typical consumer buys.

• 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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FYI: What Is in the CPI’s Basket? [BLS]

17% Transportation

15%

Food and

beverages

Medical care

6%

Recreation

6%

Apparel

4%

Other goods

and services

4%

42%

Housing

6% Education and

communication

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How the Consumer Price Index Is Calculated

Find the Prices: Find the prices 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

Compute the Basket’s Cost: Use the data on

prices to calculate the cost of the basket of

goods and services in different years.

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How the Consumer Price Index Is 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 the

basket in one year by the price in the base year and

multiplying by 100.

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How the Consumer Price Index Is Calculated

Compute the inflation rate: The inflation rate

is the percentage change in the price index from

the preceding period.

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Measuring the Cost of Living

Inflation refers to a situation in which the

economy’s overall price level is rising.

• The inflation rate is the percentage change in

the price level from the previous period.

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How the Consumer Price Index Is Calculated

• The Inflation Rate

• The inflation rate is calculated as follows:

Inflation Rate in Year 2 = CPI in Year 2 - CPI in Year 1

CPI in Year 1 100

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• http://research.stlouisfed.org/fred2/series/CPIAUCSL

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How the Consumer Price Index Is Calculated: Another Example

• Base Year is 2002

• Basket of goods in 2002 costs $1,200

• The same basket in 2004 costs $1,236

• CPI for 2004 = ($1,236/$1,200)  100 = 103

• Prices increased 3 percent between 2002 and

2004

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Problems in Measuring the Cost of Living

• The 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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Problems in Measuring the Cost of Living: 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 of living

by not considering consumer substitution.

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Substitution Bias in CPI

• Suppose Red Apples and Green Apples are the only two commodities and are identical in taste.

• Suppose the typical consumer’s basket has, for many years, contained 10 of each type.

• Suppose the prices in 2005 (the base year) were $2 per apple for both types. So, the cost of the consumer’s basket was $40 in 2005.

• Suppose the prices in 2006 are $4 for a Red Apple and $2 for a Green Apple. So, the cost of the consumer’s basket is $60 in 2006.

• Therefore, the CPI for 2006 is (60/40) × 100 = 150, indicating a 50% increase in the cost of living

• But has the cost of living really increased?

• No. The consumer can switch to zero Red Apples and 20 Green Apples and enjoy the same satisfaction as always without any increase in cost.

• Therefore, the CPI exaggerates the true cost of living.

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Problems in Measuring the Cost of Living: 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.

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Problems in Measuring the Cost of Living: 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.

• The BLS tries to adjust the price for constant

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

• The GDP deflator is calculated as follows:

GDP deflator = Nominal GDP

Real GDP 100

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The GDP Deflator Versus the Consumer Price Index

• The BLS calculates other prices indexes:

• The index for different regions within the country.

• The producer price index, which measures the cost

of a basket of goods and services bought by firms

rather than consumers. [BLS]

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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 cause them to diverge.

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The GDP Deflator Versus the Consumer Price Index

• The GDP deflator reflects the prices of all final

goods and services produced domestically,

whereas...

• …the consumer price index reflects the prices

of all final goods and services bought by

consumers.

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The GDP Deflator Versus the Consumer Price Index

• The Consumer Price Index compares the price

of a fixed basket of goods and services to the

price of the 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 base

year.

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Figure 2 Two Measures of Inflation

1965

Percent

per Year

15

CPI

GDP deflator

10

5

0 1970 1975 1980 1985 1990 2000 1995

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Correcting Economic Variables For The Effects Of Inflation

• Price indexes are used to correct for the effects

of inflation when comparing dollar figures from

different eras.

• See the BLS’s inflation calculator

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Dollar Figures From Different Times

• Do the following to convert (inflate) Babe

Ruth’s wages in 1931 to dollars in 2001:

Salary Salary

Price level in 2001

Price level in 1931 2001 1931 

 

$80, .

$931,

000 177

152

579

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Dollar Figures From Different Times

When the price of coffee

was $15.20 per cup…

… Babe Ruth’s income was

$80,000

Therefore, when the price

of coffee is $1.00 per cup…

…the equivalent income is

$80,000 ÷ 15.20

Therefore, when the price

of coffee is $177.00 per

cup…

…the equivalent income is

($80,000 ÷ 15.20) × 177 =

$931,579.

The same argument explains the calculation in the

previous slide, where the CPI is used (as the average

price) instead of the price of coffee.

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Table 2 The Most Popular Movies of All Times, Inflation Adjusted

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Indexation

• When some dollar amount is automatically

corrected for inflation by law or contract, the

amount is said to be indexed for inflation.

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Real and Nominal Interest Rates

• Interest represents a payment in the future for a

receipt of money in the past.

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Real and Nominal Interest Rates

• The nominal interest rate is the interest rate

usually mentioned in borrowing or lending

contracts.

• It is not corrected for inflation.

• It is the interest rate that a bank pays.

• The real interest rate is the interest rate that is

corrected for the effects of inflation.

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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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Figure 3 Real and Nominal Interest Rates

1965

Interest Rates

(percent

per year)

15%

Real interest rate

10

5

0

5 1970 1975 1980 1985 1990 1995 2000 2005

Nominal interest rate (3-month Treasury Bills)

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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 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

measure of the cost of living for the following

three reasons: substitution bias, the

introduction of new goods, and unmeasured

changes in quality.

• Because of measurement problems, the CPI

overstates annual inflation by about 1

percentage 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 goods and 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 use price

indexes to correct for the effects of inflation.

• The real interest rate equals the nominal interest

rate minus the rate of inflation.

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