Measuring The Cost of Living: Michael Parkin

Measuring the Cost of Living
Chapter 22
Michael Parkin
OBJECTIVES
After studying this chapter, you will be able to:

• Explain why inflation is a problem
• Explain how we measure the price level and the inflation rate
• Explain why the CPI measure of inflation may be biased
PRICE LEVEL, INFLATION, AND DEFLATION
The price level is the average level of prices and the value of
money.
 A persistently rising price level is called inflation.
 A persistently falling price level is called deflation.
We are interested in the price level because we want to

 Measure the inflation rate or the deflation rate
 Distinguish between money values and real values of
economic variables.
Why Inflation and Deflation Are Problems?

Low, steady, and anticipated inflation or deflation is not a problem.
Unpredictable inflation or deflation is a problem because it
 Redistributes income: Workers and employers sign wage
contracts that last for a year or more. An unexpected burst of
inflation raises prices but doesn’t immediately raise the wages.
Workers are worse off because their wages buy less and employers
are better off because their profits rise.
 Redistributes wealth: People enter into loan contracts that are
fixed in money terms and that pay an interest rate agreed as a
percentage of the money borrowed and lent. With unexpected
inflation, the money that the borrower repays to the lender buys
less than the money originally loaned. The borrower wins and the
lender loses.
 Lowers real GDP and employment: Unexpected inflation that

raises firms’ profits brings a rise in investment and a boom in
production and employment. Real GDP rises above potential GDP
and the unemployment rate falls below the natural rate. But this
situation is .temporary. Profitable investment dries up, spending falls,
real GDP falls below potential GDP and the unemployment rate rises.
 Diverts resources from production: Unpredictable inflation or
deflation turns the economy into a casino and diverts resources from
productive activities to forecasting inflation. It can become more
profitable to forecast the inflation rate or deflation rate correctly than
to invent a new product. From a social perspective, the diversion of
talent that results from unpredictable inflation is like throwing scarce
resources onto a pile of garbage. This waste of resources is a cost of
inflation.
THE CONSUMER PRICE INDEX
 The price level is the “average” level of prices and is measured by

using a price index. The consumer price index, or CPI, measures
the average level of the prices of goods and services consumed by
an urban family.
 The CPI is used to monitor changes in the cost of living (i.e. the
selected market basket) over time. When the CPI rises, the typical
family has to spend more dollars to maintain the same standard of
living.
Reading the CPI Numbers

 The CPI is defined to equal 100 for the base period.
 The value of the CPI for any other period is calculated by taking
the ratio of the current cost of a market basket of goods to the cost
of the same market basket of goods in the reference base period
and multiplying by 100.
Constructing the CPI involves:
 Selecting the CPI basket
 Conducting a monthly price survey
 Using the prices and the basket to calculate the CPI
CONSTRUCTING THE CPI
The Steps involved in constructing the CPI include:

 Selecting the CPI basket: This basket contains the goods and
services represented in the index, each weighted by its relative
importance in the budget of an average urban household. the BLS
conducts a Consumer Expenditure Survey.
 Conducting a monthly price survey: Each month, BLS employees
check the prices of the 80,000 goods and services in the CPI basket in
30 metropolitan areas..
 Calculating the CPI:
1. Find the cost of the CPI basket at base-period prices.
2. Find the cost of the CPI basket at current-period prices.
3. Calculate the CPI for the base period and the current period.
THE CPI BASKET
 The figure illustrates the

CPI basket, which consists
of the items that an average
urban household buys.
 Shelter is the largest
component.
 Transportation and food
are the next largest
components.
 The remaining
components account for
36.5 percent of the basket.
CPI CALCULATION
Let’s work an example of the CPI calculation.

In a simple economy, people consume only oranges and haircuts.
The CPI basket is 10 oranges and 5 haircuts. The table also shows
the prices in the base period.
The cost of the CPI basket in the base period was $50
CPI CALCULATION
This table shows the prices in the current period.
The cost of the CPI basket in the current period is $70.

CPI CALCULATION
 The CPI is calculated using the formula:

 CPI = (Cost of basket in current period/Cost of basket in
base period) x 100.
 Using the numbers for the simple example,
 CPI = ($70/$50) x 100 = 140.
 The CPI is 40 percent higher in the current period than it
was in the base period.
CPI & INFLATION
Measuring Inflation
 The main purpose of the CPI is to measure inflation.
 The inflation rate is the percentage change in the price level
from one year to the next.
 The inflation formula is:
 Inflation rate = [(CPI this year – CPI last year)/CPI last year] 
100.
C
P
I
E
X
A
M
P
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E
THE RELATIONSHIP BETWEEN THE PRICE
LEVEL AND THE INFLATION RATE
Figure 22.7(a) shows the CPI from 1970 to 2010 and Figure 22.7(b)
shows that the inflation rate is
 High when the price level is rising rapidly and
 Low when the price level is rising slowly.
VERSUS THE GDP DEFLATOR
GDP deflator & CPI give some what different information about
what’s happening to the overall level of prices in the economy.
Three Key Differences:
1. GDP deflator measures the prices of all goods and services
produced whereas CPI measures the prices of only the
goods and services bought by consumers
2. GDP deflator includes only those goods produced
domestically. Imported goods are not a part of GDP and do
not show up in the GDP deflator. On the other hand, CPI
include imported goods.
3. CPI is computed using a fixed basket of goods whereas
GDP deflator allows the basket of goods to change over
time
THE BIASED CPI
The CPI may overstate the true inflation for four reasons:
 New goods bias
 Quality change bias
 Commodity substitution bias
 Outlet substitution bias
THE BIASED CPI
1. New Goods Bias
 New goods that were not available in the base year appear and, if they are
more expensive than the goods they replace, the price level may be biased
higher.
 Similarly, if they are cheaper than the goods they replace, but not yet in the
CPI basket, they bias the CPI upward.
2. Quality Change Bias
 Quality improvements generally are neglected, so quality improvements that
lead to price hikes are considered purely inflationary.
3. Commodity Substitution Bias
 The market basket of goods used in calculating the CPI is fixed and does not
take into account consumers’ substitutions away from goods whose relative
prices increase.
4. Outlet Substitution Bias
 As the structure of retailing changes, people switch to buying from cheaper
sources, but the CPI, as measured, does not take account of this outlet
substitution.
CONSEQUENCES OF THE BIAS
The bias in the CPI:

 Distorts private contracts,
 Increases government outlays (close to a third of government
outlays are linked to the CPI)
 Biases estimates of real earnings.
To reduce the bias in the CPI, Statistics Canada undertakes consumer
expenditure surveys more frequently and revises the CPI basket
frequently and makes other adjustments to minimize the bias.
 CPI overstates inflation by 1.1 percentage points a year.
EFFECTS OF INFLATIONS
PRACTICE QUESTION
In a simple economy, people consume only 2 goods, food and

clothing. The market basket of goods used to compute the CPI
has 50 units of food and 10 units of clothing. The prices for
these for the years 2012 and 2013 are given below:
Year Food Clothing
2012 $4 $10
2013 $6 $20
1. Calculate the value of the basket and CPI for each year.
2. Calculate the inflation rate for year 2013.

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Measuring the Cost of Living

After studying this chapter, you will be able to:

We are interested in the price level because we want to

Why Inflation and Deflation Are Problems?

 Lowers real GDP and employment: Unexpected inflation that

 The price level is the “average” level of prices and is measured by

Reading the CPI Numbers

The Steps involved in constructing the CPI include:

 The figure illustrates the

Let’s work an example of the CPI calculation.

This table shows the prices in the current period.

The cost of the CPI basket in the current period is $70.

 The CPI is calculated using the formula:

The bias in the CPI:

In a simple economy, people consume only 2 goods, food and

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