Measuring The Cost of Living

1
Chapter 11

• Measuring The Cost of Living

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Ch 11 Outline

• CPI How Computed
• Calculating Inflation rate
• Problems with CPI
• Comparing Salaries over Different Times
• Real vs Nominal Interest Rates

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Green Falls Group 4
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Measuring the Cost of Living

• BLS identifies market basket that typical
  consumer buys.
• BLS surveys consumers to find price what they
  buy.

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Which Has Greatest Weight in CPI?

• Medical Care
• Transportation
• Food Beveridges
• Housing
• Entertainment

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Measuring the Cost of Living

• The Consumer Price Index (CPI) monitors changes
  in market basket over time.
• CPI reports movement an index number.

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Whats in the CPIs Basket? (Figure 11-1)
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What is an Index Number?

• Index Number has a base (starting with 100)
  that shows change in price of market basket over
  time.

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Other Price Indexes

• Other Price Indexes
• Specific geographic regions
• Narrow categories (e.g. food, clothing, etc.)
• Producer resource costs (i.e. producer price
  index)

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Calculating the Consumer Price Index and the
Inflation Rate

• Step 1 Fix the Basket
• Step 2 Find the Prices
• Step 3 Compute the Baskets Cost
• Step 4 Choose Base Year
• Step 5 Calculate Inflation rate

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Example of CPI Calculation

• STEP 1 Establish Market Basket
• 2 Furbies 1 Trollie

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How to Calculate CPI

• Step 2 Find Prices
• Year Price Furbie Price Trollie
• 1999 10 1
• 2000 12 2
• 2001 10 8

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How to Compute CPI

• Step 3 COMPUTE COST OF BASKET
• YEAR COST OF BASKET
• 1999 10(2) 1(1) 21
• 2000 12(2) 2(1) 26
• 2001 10(2) 8(1) 28

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How to Compute CPI

• Step 4 CHOOSE BASE YEAR COMPUTE INDEX
  NUMBERS
• YEAR INDEX NUMBER
• 1999 21/21 X 100 100.0
• 2000 26/21 X 100 123.8
• 2001 28/21 X 100 133.3

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Calculating Change

• CHANGE Y2 - Y1 X 100
• Y1
  

Pluggin en da numbas Y1 10, Y2 12
Change ((12-10)/10) X 100 (2/10)
X 100 20 percent
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How to Compute CPI

• YEAR INDEX NUMBER
• 1999 100.0
• 2000 123.8
• 2001 133.3

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How to Compute CPI

• Step 5 COMPUTE INFLATION RATES
• YEAR INFLATION RATE
• 2000 ((123.8-100.0)/100.0 )X10023.8
• 2001 ((133.3 - 123.8)/123.8)X100 7.7

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How to Compute CPI

• YEAR INDEX NUMBER
• 1999 100.0
• 2000 123.8
• 2001 133.3

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1
1
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Classifying Inflation

• Price Index for 3 Years
• 100 98 96 Deflation
• 100 101 102 Creeping Inflation
• 100 120 130 Disinflation
• 100 200 800 Hyperinflation

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Problems in Measuring The Cost of Living

• CPI not a perfect measure of cost of living.
• Three problems
• Substitution Bias
• Introduction of new goods
• Unmeasured quality change

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Problems of CPI Substitution Bias

• Consumers substitute toward goods that become
  less expensive

Dropped into see how were doing
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Problems of CPI New Goods

• New Products More Variety.
• So need fewer dollars to maintain standard of
  living. (VCRs, Laptops)

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Problems of CPI Quality Changes

• Quality changes might not be reflected in goods
  prices. (Ex Faster cars, smaller candy bars)

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Problems of CPI

• CPI overstates rise in cost of living by about 1
• This measurement error overstates true cost of
  living.

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The Consumer Price Index versus the GDP Deflator

• The CPI
• only consumer goods
• includes cost of imports
• fixed market basket
• The GDP Price Deflator
• all final goods and services
• excludes imports
• uses current bundle of goods

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Correcting for Inflation

• Price indexes help adjusting figures for
  inflation.
• figures automatically corrected for inflation
  are indexed for inflation.
• e.g., COLAs and Social Security

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Adjusting For InflationWhat are 1960 earnings
of 8,000 worth in 1995?

• Y2 Y1 X CPI 2
• 
  CPI 1
  

• ? 8,000 X 130.7
• 29.6
  
  

• 35,324 8,000 X 130.7
• 29.6
  
  

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Real and Nominal Interest Rates
No more formulas!

• Interest rate price of borrowing money
• Nominal interest rate
• Rate bank pays in current value.
• Real interest rate
• Interest rate corrected for inflation.
• Real interest Nominal - Inflation
  
• Rate Rate Rate

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Real Rate Nom. Rate - Inflation Rate

• ? 5 - 0
• 5 5 - 0
• ? 5 - 3
• 2 5 - 3
• ? 5 - (- 1)
• 6 5 - (- 1)

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Checking Out CPI on BLS Web Site

• Overall...
• For medical care
• For NYC...