The CPI and the Cost of Living

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The CPI and the Cost of Living

• Outline
• Index numbers
• The Consumer Price Index (CPI)
• The CPI and the Inflation Rate
• Adjusting the money (nominal) wage for inflation
  using the CPI
• The Costs of Inflation
• Is the CPI accurate?
• Consequences of overstating inflation

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Index numbers

• An index is a series of numbers used to track a
  variables rise or fall over time.
• Index numbers are meaningful in a relative
  senseby comparing one periods index number with
  that of another period.

In general, an index number is calculated as
Value of the measure in the current period
? 100
Value of the measure in the base period
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Example Violent Acts on TV
We select the year 1996 as our base year, or
benchmark period. In that year, there were 10,433
violent acts on TV. Thus, our index for the
current year would be calculated as follows
Number of violent acts in the current year
? 100
10,433
If there were 14,534 acts in 2000, then
Thus, TV violence increased by 39.3 percent
between 1996 and 2000.
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Inflation
prices
Inflation is a sustained increasein the prices
of goods and services(or the cost of living). To
measureinflation, we look at changes in
theprice of a market basket of goodsor services
households typicallypurchase with their income
Time
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The Consumer Price Index (CPI)

• We use the CPI to measure changes in the cost of
  living experienced by households.
• The CPI is the narrow price index in that the
  market basket used to construct it includes items
  purchased by households.
• Bureau of Labor Statistics economic assistants
  check the prices of 80,000 items in 30
  metropolitan areas each month.
• The inflation rate is simply the percentage
  change in the CPI from one period to the next.
• 1982-84 is the reference base period

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The BLS now revises the market basket every 2
years
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Calculating the CPI

• The CPI calculation has 3 steps
• Find the cost of the CPI market basket at base
  period prices.
• Find the cost of the CPI at current period
  prices.
• Calculate the CPI for the base period and the
  current period.

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(a) The cost of the CPI market basket a base
period prices 2000
  CPI Basket CPI Basket
Cost of
Item Quantity Price CPI Basket
Oranges 10 1 each 10
Haircuts 5 8 each 40
Cost of the market basket at base period prices Cost of the market basket at base period prices Cost of the market basket at base period prices 50
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(b) The cost of the market basket at current
period prices
  CPI Basket CPI Basket
Cost of
Item Quantity Price CPI Basket
Oranges 10 2 each 20
Haircuts 5 10 each 50
Cost of the market basket at base period prices Cost of the market basket at base period prices Cost of the market basket at base period prices 70
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Computing the CPI
Cost of CPI market basket at current prices
CPI
Cost of CPI market basket at base period prices
Thus for 2000 we have
And for 2003 we have
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Consumer Price Index (1982-84 100)
Source www.bls.gov
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The inflation rate
The inflation rate is measured by the percent
increase in the CPI from one period (month or
year) to the next. To compute the inflation rate
(CPI in the current year CPI in the previous
year)
Inflation rate
CPI in previous year
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To compute the 2002 inflation rate
CPI
Dec., 2001 177.3
Dec., 2002 181.6
Thus
Inflation rate
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On average, the prices of goodsand services in
the CPI market basketincreased by 2.4 from 2001
to 2002
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The inflation myth
Inflation cannot by itself decrease average real
income. Inflation can shift purchasing power
from some groups to others
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Redistributive Costs of Inflation
Inflation in not an equal opportunity villain.
That is, inflation arbitrarily, and unfairly,
redistributes real income
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The race to stay ahead of inflation

• Inflation erodes the purchasing power of income
  and sets off a race to stay ahead of the cost of
  living.
• Teachers, fireman, truck drivers, nurses,
  accountants, plumbers, social security
  recipients, and others strive to increase their
  incomes so as not to suffer a decrease in their
  standard of living.
• Some groups do better than others.

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Seattle Transit Workers
Ave. Income of Seattle Transit Employees
The question is were we betteroff in 2000
interms of realpurchasingpower?
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Are Seattle transit employees any better off, at
least based on these figures?
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Why are we smiling? Because our social security
benefits are indexed to the CPI
Why doesnt Congress index the minimum wage to
the CPI?
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Value of the Federal Minimum Wage
Source U.S. Department of Labor
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Unexpected inflation redistributes real income
from lenders to borrowers

• Repayments schedules for most debt contracts are
  fixed in nominal or money termsthat is, debts
  are not indexed to inflation.
• Inflation erodes the real value of repayments.

Savings Loan institutions lost money on long
term mortgages in the70s and 80s.
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We bought this house in 1957 for 19,000. We
financed the house on a 30 year mortgage note at
3.5 percent interest. Can you guess what our
monthly payment was?
Answer 85.32
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Inflation undermines confidence in political
leaders and institutions
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Is the CPI accurate?
The Boskin Commission reported to Congress in
1996 that the CPI over-estimated the actual
inflation rate in recent years by an average of
about 1.1. Many economists challenge the Boskin
findings however, most agree that inflation is
overstated by the CPI
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Sources of bias in the CPI

• New Goods bias New items such as cellular
  phones, pagers, and PCs enter the CPI market
  basket with a lag. The prices of these items has
  fallen as their popularity has risen.
• Quality bias For example, the CPI does not
  fully adjust for the fact car prices rise because
  of new features such as air bags and antilock
  brakes. Another example the cost of
  hospitalization.
• Substitution bias People tend to substitute
  relatively cheaper items in place of those that
  have become relatively more expensive.
• Outlet Substitution bias People react to higher
  retail prices by shopping at the big box high
  volume discount retailers such as Wal-Mart and
  Home Depot. Also, internet shopping for airline
  tickets, hotels, and other items allows people to
  stretch their spending power.

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What are consequences of overstating inflation?

• Changes in real income over time are not measured
  properly.
• Private contracts are distorted.
• Increase in government outlays

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This table indicates the average real wage
decreased by about 10 percent between 75 and
95. But if the CPI has an upward bias of 1.1
percent per year, then the real wage actually
increased by 11 percent during this period
Source Department of Labor
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We have a three-year contract with our hourly
employees that is indexed to the CPI
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• Federal outlays indexed to the CPI include
• Benefits of 44 million social security
  recipients
• Food stamps received by 22 million
• Benefits received by 4 million retired military
  personnel and civil servants (or surviving
  spouses).