Macroeconomics Chapter 8: The Cost of Living

Macroeconomics - Chapter 8: The Cost of Living

• GDP provides no information on purchasing power within a country
• Cost of living is based on a comprehensive view of prices and incomes
• A consistent rate of price and income change globally would simplify cost of living calculations
• Measuring price changes over time is complex
• Economists track individual price changes, weighting items by their proportion of a typical consumer's budget
• This process establishes a measure of how overall cost of living has evolved

Measuring Price Changes Over Time

• Some price changes matter more than others to consumers
• Key factors are:
  • Magnitude of price change
  • Proportion of budget allocated to the item
• Economists track price changes, prioritizing impactful items in consumer's budgets
• This method measures changes to the overall cost of living

The Consumer Price Index (CPI)

• A commonly used index to track changes in cost of living within a typical Canadian household
• Statistics Canada computes and reports the CPI monthly
• Data encompass over 600 different goods and services

Four Steps to Compute CPI and Inflation Rate

1. Determine the market basket:

   • List specific goods and services with fixed quantities corresponding to typical household spending (using FAMEX)
   • Basket weights are available

2. Compute the cost of the market basket: Determine the current prices of all goods and services in the basket

3. Choose base year: Statistics Canada uses 2002

   • Calculate the CPI for the current year
   • The formula for calculating the CPI for a current year is: CPI for current year = (Cost of basket in current year / Cost of basket in base year) * 100

4. Compute the Inflation Rate:

   • Calculate the inflation rate using the formula: Inflation rate = [(CPI<sub>t</sub> - CPI<sub>t-1</sub>) / CPI<sub>t-1</sub>] * 100%

   • where CPI_t is the CPI for the current year and CPI_t-1 is the CPI from the prior year

The Consumer Price Index (continued)

• Variety of CPI calculations available (e.g., headline inflation, core inflation, CPI-common, CPI-median, CPI-trim)
• Headline inflation tracks changes in prices for the entire market basket of the average urban household
• Core inflation measures price changes in the underlying trend of inflation
• Statistics Canada provides multiple measures to capture the nuances in inflation trends

Challenges in Measuring Price Changes

• CPI aims to balance consumer consumption across different life stages and situations
• Represents an average across a large consumer population
• Requires adjustments for changes in prices, trends, innovation, and substitutions within goods and services
• Frequent updates to maintain accuracy by using a consistently updated market basket
• Aims to reflect the cost of maintaining a given standard of living

CPI and COVID-19

• COVID-19 caused significant shifts in spending patterns
• This made the standard CPI less effective as an indicator
• Statistics Canada created an adjusted CPI that considered pandemic spending changes

Using Price Indices

• Comparing dollar figures across different time periods using price indices
• Indexing automatically adjusts payments (e.g., wages) to match the rising cost of living (COLA)

Deflating Nominal Variables

• Incomes should naturally rise with time to account for inflation in macroeconomic theory
• Calculating the current value of past dollar amounts using: Current Value<sub>year Y</sub> = Past Value<sub>year X</sub> x [(CPI<sub>year Y</sub>) / (CPI<sub>year X</sub>)]

Other Price Indices

• Producer Price Index (PPI): Measures prices of goods and services purchased by firms (includes capital goods and raw materials, often excluded from consumer baskets)
• World Bank's International Comparison Program (ICP) Index: Primary gauge for international price comparisons. This index is used by the World Bank and others.

Other Price Indices (continued)

• Purchasing Power Parity (PPP): Predicts that goods cost the same globally after accounting for exchange rates
• PPP-adjusted GDP adjusts for differences among countries in the cost of goods and services across countries. This allows for a more accurate comparison of economic output.

Explore the intricate concepts surrounding the cost of living as discussed in Macroeconomics Chapter 8. This chapter delves into how GDP fails to reflect purchasing power and the importance of measuring price changes over time. Gain insight into the Consumer Price Index (CPI) and factors affecting cost measurements.