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The CPI and the Cost of Living

6. The CPI and the Cost of Living. CHAPTER. THE CONSUMER PRICE INDEX. What is meant by inflation? Why is it important? Defn : The rate of inflation is the percentage change in the general price level from one period to the next.

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The CPI and the Cost of Living

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  1. 6 The CPI and the Cost of Living CHAPTER

  2. THE CONSUMER PRICE INDEX What is meant by inflation? Why is it important? Defn: Therate of inflation is the percentage change in the general price level from one period to the next. Defn: Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. Calculating CPI • Identify the market basket • Find the prices of each good • Compute the cost of the basket • Use the basket cost in the base year to calculate the index.

  3. THE CONSUMER PRICE INDEX Fun Fact

  4. CPI in current year  CPI in previous year x 100 Inflation rate = CPI in previous year Calculating the Inflation Rate

  5. Example If 2006 is the base year. • Calculate the CPI in 2007. • Calculate the 2007 inflation rate and interpret the number. • What percent of household budget is spent on books in 2007.

  6. Solution • Cost of market basket in 2006 = (2*$30)+(20*$2)= $100 Cost of market basket in 2007 = (2*$40)+(20*$4)= $160 CPI in 2007= (160/100)*100= 160 2) 2007 inflation rate = [(CPI in 07-CPI in 06)/CPI in 06 ]*100 n.b Inflation is calculated using the previous year NOT the base year. inflation= (160-100)/100 = 60%

  7. Solution contd. 3) Household budget in 2007 = 4*$40+10*$4 = $200 percentage spent on books = ($160/$200)*100= 80%

  8. 6.2 THE CPI AND OTHER PRICE LEVEL MEASURES CPI is not a perfect measure of the C.O.L due to certain biases. The idea is that we want to compare cost of living over time. • Sources of Bias in the CPI The potential sources of bias in the CPI are • New goods bias • Quality change bias • Commodity substitution bias • Outlet substitution bias

  9. THE CPI AND OTHER PRICE LEVEL MEASURES Alternative Measures of the Price Level 1) The GDP deflator GDP deflator = (Nominal GDP  Real GDP)  100. The inflation rate can also be calculated using the GDP deflator. 2) The personal consumption expenditures deflator (PCE deflator) The PCE deflator is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices. Idea: Is a subset of the GDP deflator.

  10. NOMINAL AND REAL VALUES Nominal vs Real Values Examples 1)Nominal GDP and real GDP (recall) 2)Nominal wage rate and real wage rate 3)Nominal interest rate and real interest rate Real interest rate = Nominal interest rate – Inflation rate Converting from nominal to real value Real value= nominal value/ Price Level (CPI or GDP deflator) Converting from year T into today’s dollars Value today= Value in yr T * ( Price level today/ Price level Yr T)

  11. Use of CPI Three good uses: calculate inflation, calculating the expected price, calculating real value. Ex. If CPI in 2007= 150, the CPI in 1995= 120. A Nintendo costs $200 in 1995. What is the price of a Nintendo in 2007. Price 07= (price in 95 ) X (CPI 07/ CPI 95) Price in 07 =$200*1.52 = $250 2)Nominal wage in 2007 was $10/ hr. If 2007 CPI=150, what is the real wage. i.e the wage in base year price? Real wage= (nominal value/CPI )*100= ($10/150)*100= $6.667

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