Chapter 25 CPI and Inflation

Principles of
Economics, 10e
Chapter 25: Measuring the Cost of
Living
Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted
to a publicly accessible website, in whole or in part. 1
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:

• Explain the welfare effects of inflation in a given scenario.
• Calculate the annual inflation rate for a specified year, given CPI data.
• Explain the differences between the GDP deflator and the CPI.
• Calculate the CPI, given pricing and consumption data on a fixed basket of goods.
• Explain why the producer price index is useful in predicting changes in the consumer
price index.
Chapter Objectives (2 of 2)
• Determine how a scenario will cause the CPI to bias the true cost of living.
• Compare the value of a dollar in the past to the value of a dollar today.
• Describe the relationship between the nominal interest rate, inflation, and the real
interest rate.
25-1
The Consumer Price Index
The Consumer Price Index (CPI)
• Consumer price index*

• A measure of the overall cost of the goods and services bought by a typical
consumer
• Monitors changes in the cost of living over time
• Computed and reported every month by the Bureau of Labor Statistics
*Words accompanied by an asterisk are key terms from the chapter.
How the CPI Is Calculated (1 of 2)
1. Fix the basket

• The Bureau of Labor Statistics (BLS) surveys consumers to find the basket of goods
and services bought by the typical consumer
2. Find the prices
• The BLS collects data on the prices of all the goods in the basket
3. Compute the basket’s cost

• Use the prices to compute the total cost of the basket
• Isolate the effects of price changes
How the CPI Is Calculated (2 of 2)
4. Chose a base year and compute the index
• Designate a year as base year (benchmark)
Ba s ke t 's c os t in c u rre n t ye a r  CPI in ye a r 1

CPI   10 0
Ba s ke t 's c os t in b a s e ye a r
5. Compute the inflation rate
CPI in ye a r 2  CPI in ye a r 1
In fla t ion ra t e in ye a r 2   10 0
CPI in ye a r 1
Table 1 Calculating the Consumer Price Index and
the Inflation Rate: An Example (1 of 3)
This table shows how to calculate the CPI and the inflation rate for a hypothetical economy in
which consumers buy only hot dogs and hamburgers.
Step 1: Survey Consumers to Determine a Fixed
• Basket of Goods Basket = 4 hot dogs, 2 hamburgers
Step 2: Find the Price of Each Good in Each Year
Year Price of Hot Dogs Price of Hamburgers
2022 $1 $2
2023 $2 $3
2024 $3 $4
Step 3: Compute the Cost of the Basket of Goods in Each Year
2022 ($1 per hot dog × 4 hot dogs) + ($2 per hamburger × 2 hamburgers) = $8 per basket
Step 4: Choose One Year as a Base Year (2022) and Compute the CPI in Each Year
2022 ($8/$8) × 100 = 100
2023 ($14/$8) × 100 = 175
2024 ($20/$8) × 100 = 250
Step 5: Use the CPI to Compute the Inflation Rate from Previous Year
2023 (175 − 100)/100 × 100 = 75%

2024 (250 − 175)/175 × 100 = 43%
Figure 1 The Typical Basket of Goods and Services
This figure shows how the typical consumer divides

spending among various categories of goods and
services. The Bureau of Labor Statistics calls each
percentage the “relative importance” of the category.
Source: U.S. Department of Labor; U.S. Department of Commerce.
Figure 1 The Typical Basket of Goods and Services
Active Learning 1: CPI & Inflation Rate ***
Year Price of Beef Price of Chicken

2021 $3 $3
2022 $4 $4
2023 $8 $5
CPI basket: 10 lbs of beef, 20 lbs of chicken

Base year: 2021
A. Calculate CPI for all years.
B. What was the inflation rate from 2022-2023?
Active Learning 1: Answers
Year Price of Beef Price of Chicken Cost of Basket
2021 $3 $3 ($3 × 10) + ($3 × 20) = $90
2022 $4 $4 ($4 × 10) + ($4 × 20) = $120
2023 $8 $5 ($8 × 10) + ($5 × 20) = $180
A. CPI
2021: 100 × (90/90) = 100
2022: 100 × (120/90) = 133.3
2023: 100 × (180/90) = 200
20 0  133.3
B. Inflation rate 2022–2023:  10 0 = 50 %
133.3
Active Learning 2: New Basket, CPI & Inflation
Rate
Year Price of Beef Price of Chicken
2021 $3 $3
2022 $4 $4
2023 $8 $5
New CPI basket for 2023: 5 lbs of beef, 25 lbs of chicken

Base year: 2021
A. Calculate cost of new basket for 2023 and CPI for 2023.
B. What is the new inflation rate from 2022-2023?
Active Learning 2: Answers
Year Price of Beef Price of Chicken Cost of Basket
2021 $3 $3 $90
2022 $4 $4 $120
2023 $8 $5 ($8 × 5) + ($5 × 25) = $165
A. CPI
2021: 100
2022: 133.3
2023: 100 × (165/90) = 183.3
18 3.3  133.3
B. Inflation rate 2022–2023:  10 0 = 37.5%
133.3
Measures of Inflation
• Inflation rate*
• The percentage change in the price index from the preceding period
• Core CPI*
• Measure of the overall cost of consumer goods and services excluding food and
energy
• Producer price index (PPI)*
• Measure of the cost of a basket of goods and services bought by firms
• Changes in PPI are often thought to be useful in predicting changes in CPI
Problems in Measuring the Cost of Living
• Substitution bias
• Introduction of new goods
• Unmeasured quality change
Substitution Bias
• Over time, 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
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
Unmeasured Quality Change
• Improvements in the quality of goods in the basket increase the value of each dollar
• The BLS tries to account for quality changes but probably misses some, as quality is
hard to measure
The GDP Deflator versus the Consumer Price
Index
• GDP deflator • CPI
• Ratio of nominal GDP to real GDP • Reflects prices of goods & services
• Reflects prices of all goods & bought by consumers
services produced domestically • Compares price of a fixed basket of
• Compares price of currently produced goods and services to price of the
basket in the base year
goods and services to price of the
same goods and services in the base
year
Figure 2 Two Measures of Inflation
This figure shows the inflation rate—the percentage change
in the level of prices— as measured by the GDP deflator
and the CPI using annual data since 1965. Notice that the
two measures of inflation generally move together.
Figure 2 Two Measures of Inflation
25-2
Correcting Economic Variables for the Effects of
Inflation
Dollar Figures from Different Times
A price index such as the CPI measures the price level and thus determines the size of the
inflation correction
Pric e le ve l t od a y
Am ou n t in t od a y’s d olla rs  Am ou n t in ye a r T d olla rs x
Pric e le ve l in ye a r T
Figure 3 Regional Variation in the Cost of Living
This figure shows how the

costs of living in the 50 U.S.
states and the District of
Columbia compare to the
U.S. average.
Source: U.S. Department of

Commerce
Indexation
• Indexation*
• The automatic correction by law or contract of a dollar amount for the effects of
inflation
• The increase in CPI automatically determines
• The COLA (cost-of-living-allowance) in many multi-year labor contracts
• Adjustments in Social Security payments and federal income tax brackets
Real and Nominal Interest Rates
• Nominal interest rate*

• Interest rate as usually reported without a correction for the effects of inflation
• Real interest rate*
• Interest rate corrected for the effects of inflation
Real interest rate = Nominal interest rate - Inflation rate
Figure 4 Real and Nominal Interest Rates
This figure shows nominal and real
interest rates using annual data since
1965. The nominal interest rate is the
rate on a three-month Treasury bill.
The real interest rate is the nominal
interest rate minus the inflation rate as
measured by the CPI. Notice that
nominal and real interest rates often
do not move together.
Source: U.S. Department of Labor; U.S. Department of Treasury.
25-3
Conclusion
Conclusion
• Persistent increases in the overall level of prices have been the norm
• Such inflation reduces the purchasing power of each unit of money
• Price indexes allow us to compare dollar figures from different points in time and,
therefore, get a better sense of how the economy is changing
Think-Pair-Share Activity
Your grandfather quit smoking cigarettes in 1995. When you ask him why he quit, you get a surprising
answer. Instead of reciting the health benefits of quitting smoking, he says, “I quit because it was just
getting too expensive. I started smoking in 1965 in Vietnam and cigarettes were only 45 cents a pack. The
last pack I bought was $2.00 and I just couldn’t justify spending more than four times as much on cigarettes
as I used to.”
A. In 1965, the CPI was 31.5. In 1995, the CPI was 152.4. While it is commendable that your grandfather
quit smoking, what is wrong with his explanation?
B. What is the equivalent cost of a 1965 pack of cigarettes measured in 1995 prices?
C. What is the equivalent cost of a 1995 pack of cigarettes measured in 1965 prices?
D. Do both methods give you the same conclusion?
Self-Assessment
• Does an increase in the price of imported goods affect the CPI or the GDP deflator
more? Why?
Summary
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Principles of

By the end of this chapter, you should be able to:

• Consumer price index*

*Words accompanied by an asterisk are key terms from the chapter.

1. Fix the basket

3. Compute the basket’s cost

Ba s ke t 's c os t in c u rre n t ye a r  CPI in ye a r 1

5. Compute the inflation rate

Year Price of Hot Dogs Price of Hamburgers

2023 (175 − 100)/100 × 100 = 75%

This figure shows how the typical consumer divides

Source: U.S. Department of Labor; U.S. Department of Commerce.

Year Price of Beef Price of Chicken

CPI basket: 10 lbs of beef, 20 lbs of chicken

New CPI basket for 2023: 5 lbs of beef, 25 lbs of chicken

• Over time, some prices rise faster than others

Source: U.S. Department of Labor; U.S. Department of Commerce.

Source: U.S. Department of Labor; U.S. Department of Commerce.

This figure shows how the

Source: U.S. Department of

*Words accompanied by an asterisk are key terms from the chapter.

• Nominal interest rate*

*Words accompanied by an asterisk are key terms from the chapter.

Source: U.S. Department of Labor; U.S. Department of Treasury.

Click the link to review the objectives for this presentation.

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