f BASIC ECONOMICS

TUTORIAL 9
Measuring the Cost of living

THE TUTORIAL
This week’s tutorial looks at Measuring the Cost of living. Please prepare these problems
prior to attending tutorials.
 Quick Quiz (Text book)
- Chapter 24
 Problems and Applications (Text book)
- Chapter 24 (2, 5)
 True/False
 Multiple choice

READING GUIDE
Review Chapter 24 of Principles of Economics (9th edition) – N. Gregory Mankiw as
preparation for this tutorial. You should also look overcarefully your lectures notes for
Week 9.

CHAPTER 24 - SUMMARY

How the CPI is Calculated

1

1. Fix the “basket”

2. Find the prices

3. Compute the basket’s cost

4. Choose a base year and compute the index

 5. Compute the inflation rate

Probems with the CPI

2

1. Substitution Bias

- Overtime, some prices rise faster than others

- Consumers substitute toward goods that become relatively cheaper,

mitigating the effects of price increases.

- The CPI misses this substitution because it uses a fixed basket of goods

- Thus, the CPI overstates increases in the cost of living

2. Introduction of New Goods

- The introduction of new goods increases variety, allows consumers to

find products that more closely meet their needs.

- In effect, dollars become more valuable

- The CPI misses this effect because it uses a fixed basket of goods

- Thus, the CPI overstates increases in the cost of living

3. Unmeasured Quality Change

- Improvements in the quality of goods in the basket increase the value of

each dollar

- National statistical services try to account for quality changes but

probably misses some, as quality is hard to measure.

- Thus, the CPI overstates increases in the cost of living

 GDP deflator vs CPI Index
3

GDP deflator CPI Index

- reflects prices of all goods/services - reflects prices only a market basket

produced domestically (but excludes of some goods/services bought by
imports) consumers (includes imports)

- base – year prices - base-year quantity

- quantities variable - Prices variable

SHORT ANSWER

1 In a simple economy, people consume only 2 goods, food and clothing. The market
basket of goods used to compute the CPI consists of 50 units of food and 10 units of
clothing.
Food Clothing
2002 price per unit $4 $10
2003 price per unit $6 $20
a. What are the percentage increases in the price of food and in the price of
clothing?
b. What is the percentage increase in the CPI?
c. Do these price changes affect all consumers to the same extent? Explain.
2 Which is likely to have the larger effect on the CPI, a 2 percent increase in the price of
food or a 3 percent increase in the price of diamond rings? Explain.
3 List the three major problems in using the CPI as a measure of the cost of living.
4 Why does the GDP deflator give a different rate of inflation than the CPI?
 TRUE/FALSE

TRUE FALSE
1. The consumer price index is used to monitor changes in an economy’s
x
production of goods and services over time.
2. When the consumer price index falls, the typical family has to spend
x
fewer dollars to maintain the same standard of living.
3. Economists use the term inflation to describe a situation in which the
x
economy’s overall price level is rising.
4. If the current year CPI is 140, then the price level has increased 40
x
percent since the base year.
5. Substitution bias occurs because the CPI ignores the possibility of
consumer substitution toward goods that have become relatively less x
expensive.
6. Substitution bias causes the CPI to understate the increase in the cost of
living from one year to the next. x

7. The CPI does not reflect the increase in the value of the dollar that
x
arises from the introduction of new goods.
8. When the price of Italian wine rises, this change is reflected in the U.S.
x
CPI but not in the U.S. GDP deflator.
9. The group of goods and services used to compute the GDP deflator
changes automatically over time, but the group of goods and services x
used to compute the CPI does not.

MULTIPLE CHOICE

1. The consumer price index is used to :

Ⓐ convert nominal GDP into real GDP Ⓒ characterize the types of goods and
services that consumers purchase
Ⓑ turn dollar figures into meaningful Ⓓ measure the quantity of goods and .........
measures of purchasing power services that the economy
produces
2. Which of the following is not correct?
Ⓐ The consumer price index gives Ⓒ The consumer price index is used
economists a way of turning dollar by economists to measure the
figures into meaningful measures of inflation rate
purchasing power .........
Ⓑ The consumer price index is used to Ⓓ The consumer price index is used
monitor changes in the cost of living to measure the quantity of goods
over time and services that the economy is
producing
3. When the consumer price index rises, the typical family
Ⓐ has to spend more dollars to Ⓒ finds that its standard of living is
maintain the same standard of living not affected .........
Ⓑ can spend fewer dollars to maintain Ⓓ can offset the effects of rising
the same standard of living prices by saving more
4. Economists use the term inflation to describe a situation in which
Ⓐ some prices are rising faster than Ⓒ the economy's overall price level
others is high, but not necessarily rising
Ⓑ the economy's overall price level is Ⓓ the economy's overall output of .........
rising goods and services is rising faster
than the economy's overall price
level
5. Which of the following is correct?
Ⓐ The GDP deflator is better than the Ⓒ The GDP deflator and the CPI are
CPI at reflecting the goods and equally good at reflecting the
services bought by consumers goods and services bought by
consumers .........
Ⓑ The CPI is better than the GDP Ⓓ The GDP deflator is more
deflator at reflecting the goods and commonly used as a gauge of
services bought by consumers inflation than the CPI is
6. The steps involved in calculating the consumer price index and the inflation rate,
in order, are as follows:
Ⓐ Choose a base year, fix the basket, Ⓒ Fix the basket, find the prices,
find the prices, compute the basket’s compute the basket's cost, choose
cost, compute the index, and a base year and compute the
compute the inflation rate index, and compute the inflation .........
rate
Ⓑ Choose a base year, fix the basket, Ⓓ Fix the basket, find the prices,
find the prices, compute the inflation compute the inflation rate,
rate, compute the basket's cost, and compute the basket’s cost, and
compute the index choose a base year and compute
 the index
7. In the CPI, goods and services are weighted according to
Ⓐ how long a market has existed for Ⓒ how much consumers buy of each
each good or service good or service
.........
Ⓑ the extent to which each good or Ⓓ the number of firms that produce
service is regarded by the and sell each good or service
government as a necessity

8. In the calculation of the CPI, coffee is given greater weight than tea if
Ⓐ consumers buy more coffee than tea Ⓒ it costs more to produce coffee
than it costs to produce tea .........
Ⓑ the price of coffee is higher than the Ⓓ coffee is more readily available
price of tea than tea is to the typical consumer
9. When computing the cost of the basket of goods and services purchased by a
typical consumer, which of the following changes from year to year?
Ⓐ the quantities of the goods and Ⓒ the goods and services making up .........
services purchased the basket
Ⓑ the prices of the goods and services Ⓓ All of the above are correct

10. In computing the consumer price index, a base year is chosen. Which of the
following statements about the base year is correct?
Ⓐ The base year is always the first year Ⓒ The value of the consumer price
among the years for which index is always 100 in the base
computations are being made year .........
Ⓑ It is necessary to designate a base Ⓓ The base year is always the year
year only in the simplest case of two in which the cost of the basket
goods; in more realistic cases, it is was highest among the years for
not necessary to designate a base which computations are being
year made
11. If 2004 is the base year, then the inflation rate for 2005 equals

Ⓐ Ⓒ .........
Ⓑ Ⓓ
12. Suppose a basket of goods and services has been selected to calculate the CPI and
2002 has been selected as the base year. In 2002, the basket’s cost was $50; in
2004, the basket’s cost was $52; and in 2006, the basket’s cost was $54.60. The
value of the CPI in 2004 was .........
Ⓐ 96.2 Ⓒ 104.0
Ⓑ 102.0 Ⓓ 152.0
13. If the consumer price index was 100 in the base year and 107 in the following
year, then the inflation rate was Inflation rate = ((CPI in
Ⓐ 1.07 percent Ⓒ 10.7 percent the following year - CPI .........
in the base year) / CPI
Ⓑ 7 percent Ⓓ 107 percent in the base year) x 100 .

14. The market basket used to calculate the CPI in Aquilonia is 4 loaves of bread, 6
gallons of milk, 2 shirts, and 2 pairs of pants. In 2005, bread cost $1.00 per loaf,
milk cost $1.50 per gallon, shirts cost $6.00 each, and pants cost $10.00 per pair.
In 2006, bread cost $1.50 per loaf, milk cost $2.00 per gallon, shirts cost $7.00
each, and pants cost $12.00 per pair. Using 2005 as the base year, what was .........
Aquilonia’s inflation rate in 2006?
Ⓐ 4 percent Ⓒ 19.6 percent
Ⓑ 11 percent Ⓓ 24.4 percent
15. The price index was 110 in the first year, 100 in the second year, and 96 in the
third year. The economy experienced
Ⓐ 9.1 percent deflation between the Ⓒ 10 percent deflation between the
first and second years, and 4 percent first and second years, and 4
deflation between the second and percent deflation between the
.........
third years second and third years
Ⓑ 9.1 percent deflation between the Ⓓ 10 percent deflation between the
first and second years, and 4.2 first and second years, and 4.2
percent deflation between the percent deflation between the
second and third years second and third years
16. In a particular economy, the price index was 270 in 2005 and 300 in 2006. Which
of the following statements is correct?
Ⓐ The economy experienced a rising Ⓒ The inflation rate between 2005
price level between 2005 and 2006 and 2006 was 30 percent
.........
Ⓑ The economy experienced a higher Ⓓ All of the above are correct
inflation rate between 2005 and
2006 than it had experienced
between 2004 and 2005
17. Which of the following changes in the price index produces the greatest rate of
inflation: 80 to 100, 100 to 120, or 150 to 170?
Ⓐ 80 to 100 Ⓒ 150 to 170 .........
Ⓑ 100 to 120 Ⓓ All of these changes produce the
same rate of inflation
18. If the CPI was 125 this year and 120 last year, then
Ⓐ the cost of the CPI basket of goods Ⓒ the inflation rate for this year was
and services increased by 4.2 percent 4.2 percent
this year .........
Ⓑ the price level increased by 4.2 percent Ⓓ All of the above are correct
this year
19. In an imaginary economy, consumers buy only sandwiches and magazines. The
fixed basket consists of 20 sandwiches and 30 magazines. In 2006, a sandwich
cost $4 and a magazine cost $2. In 2007, a sandwich cost $5. The base year is
2006. If the consumer price index in 2007 was 125, then how much did a .........
magazine cost in 2007?
Ⓐ $0.83 Ⓒ $2.50
Ⓑ $2.25 Ⓓ $3.00
20. The price index was 128.96 in 2006, and the inflation rate was 24 percent between
2005 and 2006. The price index in 2005 was
Ⓐ 104 Ⓒ 152.96 .........
Ⓑ 104.96 Ⓓ 159.91
21. Suppose the price index was 100 in 2004, 118 in 2005, and the inflation rate was
lower between 2005 and 2006 than it was between 2004 and 2005. This means
that
Ⓐ the price index in 2006 was lower Ⓒ the price index in 2006 was lower than
.........
than 118 139.24
Ⓑ the price index in 2006 was lower Ⓓ the inflation rate between 2005
than 136 and 2006 was lower than 1.18
percent
Table 1
The table below pertains to Iowan, an economy in which the typical consumer’s
basket consists of 3 pounds of pork and 4 bushels of corn.
Year Price of Price of
Pork Corn .........
2008 $20 per pound $12 per bushel
2009 $25 per pound $18 per bushel

22. Refer to Table 1. The cost of the basket in 2008 was

 Ⓐ $108 Ⓒ $160
Ⓑ $147 Ⓓ $224
23. Refer to Table 1. The cost of the basket in 2009 was
Ⓐ $108 Ⓒ $160
.........
Ⓑ $147 Ⓓ $301

24. Refer to Table 1. If 2008 is the base year, then the CPI for 2008 was
Ⓐ 73.5 Ⓒ 108
.........
Ⓑ 100 Ⓓ 136.1

25. Refer to Table 1. If 2008 is the base year, then the CPI for 2009 was
Ⓐ 73.5 Ⓒ 136.1 .........
Ⓑ 100 Ⓓ 147

26. Refer to Table 1. If 2009 is the base year, then the CPI for 2008 was
Ⓐ 73.5 Ⓒ 108
.........
Ⓑ 100 Ⓓ 136.1
27. Refer to Table 1. If 2009 is the base year, then the CPI for 2009 was
Ⓐ 73.5 Ⓒ 136.1 .........
Ⓑ 100 Ⓓ 147
28. Refer to Table 1. If 2008 is the base year, then the inflation rate in 2009 was
Ⓐ 26.5 percent Ⓒ 39 percent
.........
Ⓑ 36.1 percent Ⓓ 47 percent
29. Refer to Table 1. If 2009 is the base year, then the inflation rate in 2009 was
Ⓐ 26.5 percent Ⓒ 39 percent .........
Ⓑ 36.1 percent Ⓓ 47 percent
30. By far the largest category of goods and services in the CPI basket is
Ⓐ housing Ⓒ education & communication .........
Ⓑ transportation Ⓓ food & beverages
31. In the basket of goods that is used to compute the consumer price index, which of
the following categories of consumer spending is the smallest?
Ⓐ food & beverages Ⓒ housing .........
Ⓑ recreation Ⓓ apparel

32. The goal of the consumer price index is to measure changes in the
Ⓐ costs of production Ⓒ relative prices of consumer goods .........
Ⓑ cost of living Ⓓ production of consumer goods
33. Which of the following is not a widely acknowledged problem with using the CPI
as a measure of the cost of living?
Ⓐ substitution bias Ⓒ unmeasured quality change .........
Ⓑ introduction of new goods Ⓓ unmeasured price change

34. When the relative price of a good decreases, consumers respond by buying
Ⓐ a larger quantity of that good and a Ⓒ a smaller quantity of that good
larger quantity of substitutes for that and a larger quantity of substitutes
good for that good .........
Ⓑ a larger quantity of that good and a Ⓓ a smaller quantity of that good
smaller quantity of substitutes for and a smaller quantity of
that good substitutes for that good
35. Suppose the price of a quart of milk rises from $1 to $1.25 and the price of a T-
shirt rises from $8 to $10. If the CPI rises from 150 to 175, then people likely will
buy
Ⓐ more milk and more T-shirts Ⓒ less milk and more T-shirts .........

Ⓑ more milk and fewer T-shirts Ⓓ less milk and fewer T-shirts

36. One problem with the consumer price index stems from the fact that, over time,
consumers tend to buy larger quantities of goods that have become relatively less
expensive and smaller quantities of goods that have become relatively more
expensive. This problem is called .........
Ⓐ price-change neglect Ⓒ substitution bias
Ⓑ unmeasured quality change Ⓓ relative bias
37. Suppose the price of gasoline increases rapidly and consumers respond by buying
a smaller quantity of gasoline. The consumer price index
Ⓐ reflects this price increase accurately Ⓒ overstates this price increase due
to the income bias .........
Ⓑ understates this price increase due to Ⓓ overstates this price increase due
the substitution bias to the substitution bias
38. Because the CPI is based on a fixed basket of goods, the introduction of new
goods and services in the economy causes the CPI to overestimate the cost of
living. This is so because
Ⓐ new goods and services are always Ⓒ new goods and services cost more
of higher quality than existing goods than existing goods and services
and services .........
Ⓑ new goods and services cost less Ⓓ when a new good is introduced, it
than existing goods and services gives consumers greater choice,
thus reducing the amount they
must spend to maintain their
standard of living
39. The GDP deflator reflects the
Ⓐ level of prices in the base year Ⓒ level of real output in the base
relative to the current level of prices year relative to the current level
of real output .........
Ⓑ current level of prices relative to the Ⓓ current level of real output
level of prices in the base year relative to the level of real output
in the base year
40. An important difference between the GDP deflator and the consumer price index
is that
Ⓐ the GDP deflator reflects the prices Ⓒ the GDP deflator reflects the
of goods and services bought by prices of all final goods and
producers, whereas the consumer services produced by a nation's
price index reflects the prices of citizens, whereas the consumer
goods and services bought by price index reflects the prices of
consumers all final goods and services
.........
bought by consumers
Ⓑ the GDP deflator reflects the prices Ⓓ the GDP deflator reflects the
of all final goods and services prices of all final goods and
produced domestically, whereas the services bought by producers and
consumer price index reflects the consumers, whereas the consumer
prices of goods and services bought price index reflects the prices of
by consumers all final goods and services
bought by consumers
41. The CPI differs from the GDP deflator in that
Ⓐ the CPI is a price index, while the Ⓒ increases in the prices of foreign
GDP deflator is an inflation index produced goods that are sold to
U.S. consumers show up in the
CPI but not in the GDP deflator
.........
Ⓑ substitution bias is not a problem Ⓓ increases in the prices of
with the CPI, but it is a problem with domestically produced goods that
the GDP deflator are sold to the U.S. government
show up in the CPI but not in the
GDP deflator
42. An increase in the price of dairy products produced domestically will be reflected
in
Ⓐ both the GDP deflator and the Ⓒ the GDP deflator but not in the
consumer price index consumer price index .........
Ⓑ neither the GDP deflator nor the Ⓓ the consumer price index but not
consumer price index in the GDP deflator
43. A decrease in the price of domestically produced industrial robots will be reflected
in
Ⓐ both the GDP deflator and the consumer Ⓒ the GDP deflator but not in the
price index consumer price index .........
Ⓑ neither the GDP deflator nor the Ⓓ the consumer price index but not
consumer price index in the GDP deflator
44. In the United States, if the price of imported oil rises so that the prices of gasoline
and heating oil rise, then the
Ⓐ GDP deflator rises much more than Ⓒ GDP deflator and the consumer
does the consumer price index price index rise by about the same
.........
amount
Ⓑ consumer price index rises much Ⓓ consumer price index rises
more than does the GDP deflator slightly more than does the GDP
deflator
45. If the price of Italian shoes imported into the United States increases, then
Ⓐ both the GDP deflator and the Ⓒ the GDP deflator will increase,
consumer price index will increase but the consumer price index will
not increase .........
Ⓑ neither the GDP deflator nor the Ⓓ the consumer price index will
consumer price index will increase increase, but the GDP deflator
will not increase
46. An increase in the price of Irish whiskey regularly purchased by Americans will
be reflected in
Ⓐ both the U.S. GDP deflator and the Ⓒ the U.S. GDP deflator, but not the
.........
U.S. CPI U.S. CPI
Ⓑ neither the U.S. GDP deflator nor the Ⓓ the U.S. CPI, but not the U.S.
U.S. CPI GDP deflator
47. Which is the most accurate statement about the GDP deflator and the consumer
price index?
Ⓐ The GDP deflator compares the price Ⓒ Both the GDP deflator and the
of a fixed basket of goods and consumer price index compare the
services to the price of the basket in price of a fixed basket of goods
the base year, whereas the consumer and services to the price of the
price index compares the price of basket in the base year
currently produced goods and
services to the price of the same
.........
goods and services in the base year
Ⓑ The consumer price index compares Ⓓ Both the GDP deflator and the
the price of a fixed basket of goods consumer price index compare the
and services to the price of the price of currently produced goods
basket in the base year, whereas the and services to the price of the
GDP deflator compares the price of same goods and services in the
currently produced goods and base year
services to the price of the same
goods and services in the base year