CHAPTER 6 MEASURING THE COST OF LIVING BRIEF PRINCIPLES OF MACROECONOMICS

LEARNING OBJECTIVES:

By the end of this chapter, you should understand:

Ø       how the consumer price index (CPI) is constructed.

Ø       why the CPI is an imperfect measure of the cost of living.

Ø       how to compare the CPI and the GDP deflator as measures of the overall price level.

Ø       how to use a price index to compare dollar figures from different times.

Ø       the distinction between real and nominal interest rates

KEY POINTS:

1.       The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.

2.       The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates annual inflation by about one percentage point.

3.       Like the consumer price index, the GDP deflator also measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences. The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

4.       Dollar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.

5.       Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.

6.       A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

CHAPTER OUTLINE:

I.          The Consumer Price Index

A.         Definition of consumer price index (CPI): a measure of the overall cost of the goods and services bought by a typical consumer.

B.         How the Consumer Price Index Is Calculated

1.         Fix the basket.

a.         The Bureau of Labor Statistics uses surveys to determine a representative bundle of goods and services purchased by a typical consumer.

b.         Example: 4 hot dogs and 2 hamburgers.

2.         Find the prices.

a.         Prices for each of the goods and services in the basket must be determined for each time period.

b.         Example:

3.         Compute the basket’s cost.

a.         By keeping the basket the same, only prices are being allowed to change. This allows us to isolate the effects of price changes over time.

b.         Example:

Cost in 2005 = ($1 × 4) + ($2 × 2) = $8.

Cost in 2006 = ($2 × 4) + ($3 × 2) = $14.

Cost in 2007 = ($3 × 4) + ($4 × 2) = $20.

4.         Choose a base year and compute the index.

a.         The base year is the benchmark against which other years are compared.

b.         The formula for calculating the price index is:

c.          Example (using 2005 as the base year):

CPI for 2005 = ($8)/($8) × 100 = 100.

CPI for 2006 = ($14)/($8) × 100 = 175.

CPI for 2007 = ($20)/($8) × 100 = 250.

5.         Compute the inflation rate.

a.       Definition of inflation rate: the percentage change in the price index from the preceding period.

CPI must be equal to 100 in the base year.  Inflation does not mean that the prices of all goods in the economy are rising. Inflation means that prices on average are rising. In fact, the prices of many electronic goods (such as computers and DVD players) have fallen in recent years.

b.         The formula used to calculate the inflation rate is:

c.          Example:

Inflation Rate for 2006 = (175 – 100)/100 × 100% = 75%.

Inflation Rate for 2007 = (250 – 175)/175 × 100% = 43%.

It is possible for the CPI to fall if deflation is present. Even though you have not experienced deflation in your lifetime, it has occurred during several periods of U.S. history (especially during the Great Depression).

C.         The Producer Price Index

1.         Definition of producer price index (PPI): a measure of the cost of a basket of goods and services bought by firms.

2.         Because firms eventually pass on higher costs to consumers in the form of higher prices on products, the producer price index is believed to be useful in predicting changes in the CPI.

D.         FYI: What Is in the CPI’s Basket?

1.         Figure 1 shows the makeup of the market basket used to compute the CPI.

2.         The largest category is housing, which makes up 42% of a typical consumer’s budget.

E.         In the News: Accounting for Quality Change

            1.         When considering how price changes affect consumers’ well-being, it is important to measure changes in the quality of goods and services over time.

            2.         This is an article from the Wall Street Journal that discusses how the Bureau of Labor Statistics takes product improvements into account when computing the CPI.

F.         Problems in Measuring the Cost of Living

1.         Substitution Bias

a.         When the price of one good changes, consumers often respond by substituting another good in its place.

b.         The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services.

c.          This implies that the CPI overstates the increase in the cost of living over time.

2.         Introduction of New Goods

a.         When a new good is introduced, consumers have a wider variety of goods and services to choose from.

b.         This makes every dollar more valuable, which lowers the cost of maintaining the same level of economic well-being.

c.          Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket.

3.         Unmeasured Quality Change

a.         If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises.

b.         Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure.

4.         The size of these problems is also difficult to measure.

5.         Most studies indicate that the CPI overstates the rate of inflation by approximately one percentage point per year.

6.         The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI.

G.         The GDP Deflator versus the Consumer Price Index

1.         The GDP deflator reflects the prices of all goods produced domestically, while the CPI reflects the prices of all goods bought by consumers.

2.         The CPI compares the prices of a fixed basket of goods over time, while the GDP deflator compares the prices of the goods currently produced to the prices of the goods produced in the base year. This means that the group of goods and services used to compute the GDP deflator changes automatically over time as output changes.

3.         Figure 2 shows the inflation rate as measured by both the CPI and the GDP deflator

H.         Indexation

1.         Definition of indexation: the automatic correction of a dollar amount for the effects of inflation by law or contract.

2.         As mentioned above, many government transfer programs use indexation for the benefits. The government also indexes the tax brackets used for federal income tax.

3.         There are uses of indexation in the private sector as well. Many labor contracts include cost-of-living allowances (COLAs).

I.         Real and Nominal Interest Rates

This  example makes the importance of real interest rates clear: suppose you have $100 in a savings account earning 3% interest. What will happen to the purchasing power of that money if prices rise 3% during the year. What if the inflation rate rose to 5% and then dropped to 1%?

1.         Example: Sally Saver deposits $1,000 into a bank account that pays an annual interest rate of 10%. A year later, she withdraws $1,100.

2.         What matters to Sally is the purchasing power of her money.

            a.         If there is zero inflation, her purchasing power has risen by 10%.

            b.         If there is 6% inflation, her purchasing power has risen by about 4%.

            c.          If there is 10% inflation, her purchasing power has remained the same.

            d.         If there is 12% inflation, her purchasing power has declined by about 2%.

            e.         If there is 2% deflation, her purchasing power has risen by about 12%.

3.         Definition of nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation.

4.         Definition of real interest rate: the interest rate corrected for the effects of inflation.

real interest rate=nominal interest rate-inflation rate
 

5.         Case Study: Interest Rates in the U.S. Economy

            a.         Figure 3 shows real and nominal interest rates from 1965 to the present.

            b.         The nominal interest rate is always greater than the real interest rate in this diagram because there was always inflation during this period.

            c.          Note that in the late 1970s the real interest rate was negative because the inflation rate exceeded the nominal interest rate.