MACROECONOMICS I
Anna Donina
Lecture 2
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MEASURING THE COST OF LIVING
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© 2018 CENGAGE LEARNING®. MAY NOT BE SCANNED, COPIED OR DUPLICATED, OR POSTED TO A PUBLICLY
ACCESSIBLE WEBSITE, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A
CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE OR SCHOOL-APPROVED
LOOK FOR THE ANSWERS TO THESE QUESTIONS
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI? How serious
are they?
• How does the CPI differ from the GDP deflator?
• How can we use the CPI to compare dollar amounts
from different years? Why would we want to do this,
anyway?
• How can we correct interest rates for inflation?
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THE CONSUMER PRICE INDEX
Consumer price index (CPI)
 Measure of the overall level of prices
 Measure of the overall cost of goods and
services - Bought by a typical consumer
 Computed and reported every month by the
central statistical offices
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CALCULATING CPI
1. Fix the basket
 The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices
 The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost
 Use the prices to compute the total cost of the
basket
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CALCULATING CPI
4. Chose a base year and compute the CPI
 Cost of basket of goods and services in current year
divided by cost of basket in base year
 Times 100
5. Compute the inflation rate
 The percentage change in the CPI from the preceding
period
Inflation rate =
CPI this year − CPI last year
CPI last year
× 100
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EXAMPLE: BASKET: {4 PIZZAS, 10 LATTES}
Compute CPI in each year (2014
base year)
2014: 100 x ($60/$60) = 100
2015: 100 x ($69/$60) = 115
2016: 100 x ($78/$60) = 130
$11 x 4 + $2.5 x 10 = $69
$10 x 4 + $2 x 10 = $60
cost of basket
$3.00
$2.50
$2.00
price of
latte
$122016
$112015
$102014
price of
pizza
year
Inflation rate:
15%
115 – 100
100
x 100%=
13%
130 – 115
115
x 100%=
$12 x 4 + $3 x 10 = $78
EXERCISE 1
CPI basket:
{10 kgs beef,
20 kgs chicken}
The CPI basket cost $120
in 2014, the base year.
A. Compute the CPI in 2015.
B. What was the CPI inflation rate from 2015–2016?
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price
of beef
price of
chicken
2014 $4 $4
2015 $5 $5
2016 $9 $6
EXERCISE 1 SOLUTIONS
CPI basket:
{10 kgs beef,
20 kgs chicken}
The CPI basket
cost $120 in 2014,
the base year.
A. Compute the CPI in 2015.
Cost of CPI basket in 2015 = ($5x10)+($5x20) = $150
CPI in 2015 = 100 x ($150/$120) = 125
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price
of beef
price of
chicken
2014 $4 $4
2015 $5 $5
2016 $9 $6
EXERCISE 1 SOLUTIONS
CPI basket:
{10 kgs beef,
20 kgs chicken}
The CPI basket
cost $120 in 2014,
the base year.
B. What was the CPI inflation rate from 2015–2016?
Cost of CPI basket in 2016=($9 x10)+($6 x20) = $210
CPI in 2016 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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price
of beef
price of
chicken
2014 $4 $4
2015 $5 $5
2016 $9 $6
WHAT’S IN THE CPI’S BASKET?
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EXERCISE 2 SUBSTITUTION BIAS
CPI basket:
{10 kgs beef,
20 kgs chicken}
In 2014 and 2015,
households
bought CPI basket.
In 2016, households bought {5 kgs beef, 25 kgs chicken}.
A. Compute cost of the 2016 household basket.
B. Compute % increase in cost of household basket over
2015–2016, compare it to CPI inflation rate.
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beef chicken
cost of CPI
basket
2014 $4 $4 $120
2015 $5 $5 $150
2016 $9 $6 $210
EXERCISE 2 SOLUTIONS
CPI basket:
{10 kgs beef,
20 kgs chicken}
In 2014 and 2015,
households
bought CPI basket.
In 2016, households bought {5 kgs beef, 25 kgs chicken}.
A. Compute cost of the 2016 household basket.
($9 x 5) + ($6 x 25) = $195
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beef chicken
cost of CPI
basket
2014 $4 $4 $120
2015 $5 $5 $150
2016 $9 $6 $210
EXERCISE 2 SOLUTIONS
CPI basket:
{10 kgs beef,
20 kgs chicken}
In 2014 and 2015,
households
bought CPI basket.
In 2016, households bought {5 kgs beef, 25 kgs chicken}.
B. Compute % increase in cost of household basket over
2015–2016, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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beef chicken
cost of CPI
basket
2014 $4 $4 $120
2015 $5 $5 $150
2016 $9 $6 $210
PROBLEMS WITH THE CPI
Substitution Bias
 Over time, some prices rise faster than others
 Consumers substitute toward goods that become
relatively cheaper, mitigating the effects of price
increases.
 The CPI misses this substitution because it uses a fixed
basket of goods.
 Thus, the CPI overstates increases in the cost of living.
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PROBLEMS WITH THE CPI
Introduction of New Goods
 The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
 In effect, dollars become more valuable.
 The CPI misses this effect because it uses a fixed
basket of goods.
 Thus, the CPI overstates increases in the cost of
living.
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PROBLEMS WITH THE CPI
Unmeasured Quality Change
 Improvements in the quality of goods in the basket
increase the value of each dollar.
 The BLS tries to account for quality changes but
probably misses some, as quality is hard to
measure.
 Thus, the CPI overstates increases in the cost of
living.
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PROBLEMS WITH THE CPI
Each of these problems causes the CPI to overstate cost
of living increases.
 The BLS has made technical adjustments,
but the CPI probably still overstates inflation by
about 0.5 percent per year.
 This is important because Social Security payments
and many contracts have COLAs tied to the CPI.
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TWO MEASURES OF INFLATION, 1960–2020
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CONTRASTING THE CPI AND GDP DEFLATOR
Imported consumer goods:
 Included in CPI
 Excluded from GDP deflator
Capital goods:
 Excluded from CPI
 Included in GDP deflator (if produced
domestically)
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CONTRASTING THE CPI AND GDP DEFLATOR
The basket:
 CPI uses fixed basket
 GDP deflator uses basket of currently
produced goods & services
 This matters if different prices are
changing by different amounts.
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EXERCISE 3 CPI VS. GDP DEFLATOR
In each scenario, determine the effects on the CPI and
the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. A local manufacturer raises the price of the industrial
tractors it produces.
C. Armani raises the price of the Italian jeans it sells in
the Czech Republic.
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EXERCISE 3 SOLUTIONS
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. A local manufacturer raises the price of the industrial
tractors it produces.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it sells in
the CR.
The CPI rises, the GDP deflator does not.
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CORRECTING VARIABLES FOR INFLATION
Comparing dollar figures from different times
 Inflation makes it harder to compare dollar
amounts from different times.
Example: the minimum wage in the U.S.
 $1.25 in Dec 1963
 $7.25 in Dec 2013
Did min wage have more purchasing power in Dec
1963 or Dec 2013?
To compare, use CPI to convert 1963 figure into
“2013 dollars”…
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CORRECTING VARIABLES FOR INFLATION
Dollar figures from different times
Amount in today′s dollars =
= Amount in year T dollars ×
Price level today
Price level in year T
In our example:
 “year T ” is 1963, “today” is 2013
 Min wage was $1.25 in year T
 CPI = 30.9 in year T, CPI = 234.6 today
 The minimum wage in 1963 was”
$1.25 x 234.6/30.9 = $9.49 in 2013 dollars.
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CORRECTING VARIABLES FOR INFLATION
Comparing dollar figures from different times
 Researchers, business analysts, and policymakers often
use this technique to convert a time series of currentdollar
(nominal) figures into constant-dollar (real)
figures.
 They can then see how a variable has changed over
time after correcting for inflation.
 Example: the minimum wage…
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THE U.S. MINIMUM WAGE IN CURRENT DOLLARS
AND TODAY’S DOLLARS, 1960–2013
2013
dollars
current
dollars
EXERCISE 4
Express the 1990 tuition figures in 2015 dollars, then
compute the percentage increase in real terms for all three
types of schools.
Which type experienced the largest increase in real tuition
costs?
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Tuition and Fees at U.S. Colleges and Universities
1990 2015
Private non-profit 4-year $9,340 $32,405
Public 4-year $1,908 $9,410
Public 2-year $906 $3,435
CPI 130.7 237.7
EXERCISE 4 SOLUTION
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1990 2015 % change
CPI 130.7 237.7 81.9%
Private non-profit 4-year
(current $)
$9,340 $32,405
Private non-profit 4-year
(in 2015 $)
$16,986 $32,405 90.8%
Public 4-year (current $) $1,908 $9,410
Public 4-year (in 2015 $) $3,470 $9,410 171.2%
Public 2-year (current $) $906 $3,435
Public 2-year (in 2015 $) $1,648 $3,435 108.4%
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CORRECTING VARIABLES FOR INFLATION
Real vs. Nominal Interest Rates
The nominal interest rate:
 Interest rate not corrected for inflation
 Rate of growth in the dollar value of a deposit or debt
The real interest rate:
 Corrected for inflation
 Rate of growth in the purchasing power of a deposit
or debt
Real interest rate=(nominal interest rate)–(inflation rate)
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REAL VS. NOMINAL INTEREST RATES
Example:
 Deposit $1,000 for one year.
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit
has grown 5.5%.
REAL AND NOMINAL INTEREST RATES IN THE U.S., 1960–2015
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Interestrate(percentperyear)
Real
Nominal
SUMMARY
• The Consumer Price Index is a measure of the cost of
living. The CPI tracks the cost of the typical
consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living Adjustments
and to correct economic variables for the effects of
inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate from
the nominal interest rate.
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