Chapter 23

1. Chapter 23 Measuring The Cost of Living (and Inflation)

2. Measuring the Cost of Living • In determining the cost of living, the Bureau of Labor Statistics (BLS) first identifies a “market basket” of goods and services the typical consumer buys. • Monthly, the BLS conducts surveys of the overall cost of the goods and services consumers buy.

3. Measuring the Cost of Living • The Consumer Price Index (CPI) is used to monitor changes in the cost of living. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. • The goal of the CPI is to measure changes in the cost of living. It reports the movement of prices not in dollar amounts, but with an index number.

4. What’s in the CPI’s Basket? (Figure 23-1)

5. What is an Index Number? An Index Number is the value of some entity (e.g., prices) relative to a base period. Generally, the base year has an index value equal to 100.

6. Calculating the Consumer Price Index (CPI) and the Inflation Rate • Determine the market basket. • Find the prices of each of the goods and services in the market basket. • Compute the market basket’s cost. • Designate one year as the Base Year. Compute the CPI for each year. • Use the CPI to calculate the inflation rate.

7. Calculating the CPI and the Inflation Rate The Inflation Rate is the percentage change in the CPI from the preceding period • Example: • Base Year is 1990 • Bundle of goods in 1990 = $1,200 • The same bundle in 1991 cost = $1,236 • CPI = ($1,236 ÷ $1,200) X 100 = 103 • Prices between 1990 & 1991 increased 3%

8. Calculating the CPI and the Inflation Rate Example: Table 23-1 (p. 513)

9. Consumer Price Index Values

10. Bureau of Labor Statistics Website CPI-U 1991-Present

11. Other Price Indexes • Other Price Indexes are computed for: • Specific regions within the country (e.g. Boston, New York, Los Angeles) • Narrow categories of goods and services (e.g. food, clothing, etc.) • Producer costs of resources (i.e. producer price index)

12. 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.” • Three reasons/problems: • Substitution Bias • Introduction of new goods • Unmeasured quality change

13. Problems of CPI: Substitution Bias • The bundle does not change in the short run to reflect consumer reaction to changing relative prices. • Consumers substitute toward goods that have become relatively less expensive. • CPI is computed assuming a fixed basket of goods. • The index overstates the increase in cost of living by not considering the substitution by the consumer.

14. Problems of CPI: New Goods • The bundle does not reflect the effects of new products that typically go down in price after introduction. • New products allow for greater consumer choice. • Slow introduction of new goods into the CPI leads to an overstatement of inflation.

15. Problems of CPI: Quality Changes • Higher prices usually include quality changes that do not necessarily represent a higher cost of living. • E.g., new cars have higher prices yet quality changes. • The BLS generally understates quality changes.

16. Problems of CPI • Measurement errors related to the substitution bias, the slow introduction of new goods, and unmeasured quality change suggest the CPI overstates the increase in the cost of living by about one percent (1%)

17. The Consumer Price Index versus the GDP Deflator • CPI: • includes only consumer goods • includes the cost of imports • is a fixed bundle of goods • GDP PRICE DEFLATOR (Ch. 22): • includes all final goods and services • excludes imports • uses a current bundle of goods

18. Correcting Economic Variables for the Effects of Inflation • Price indexes are used to correct for the effects of inflation when comparing $ figures from different times. • When some $ amount is corrected for inflation by law or contract the amount is said to be indexed for inflation. • e.g., COLA’s for Social Security, tax brackets, labor contracts

19. Consumer Price Index Values

20. Correcting Economic Variables for the Effects of Inflation • To convert (inflate) past wages and prices into current terms: Current Year Dollars = Past Year Nominal Value X [(Price index in current year) ÷ (Price index in past year)]

21. Converting Nominal to Real Income (inflate) $20,000 in 1954 is worth how much in 2002? $20,000 X 180.1/26.9 = $133,903

22. Correcting Economic Variables for the Effects of Inflation • To convert (deflate) current wages and prices into past year terms: Value in Past Year Dollars = Current Year Value X [(Price index in past year) ÷ (Price index in current year)]

23. Converting Nominal to Real Income (deflate) $60,000 in 1990 is worth how much in 1983? $60,000 X 99.6/130.7 = $45,723

24. Real and Nominal Interest Rates • Interest rate: the cost of borrowing funds (or the reward for lending funds) • Nominal interest rate: the “stated” interest rate. • Real interest rate: the interest rate corrected for inflation. • Real interest rate = Nominal interest rate minus the Inflation rate

25. Real and Nominal Interest Rates • Example • You borrow $1,000 for one year. • Nominal Interest rate was 15%. • During the year inflation was 10%. • The real interest rate is: 15% - 10% = 5%

26. Conclusion • When comparing dollar values from different times, it is necessary to keep in mind that a dollar today is not the same as a dollar in the past. • The CPI illustrates one way that prices are measured and how to make adjustments for these price changes. • Real vs. nominal interest rates