Chapter 11 - Measuring the Cost of Living PDF

11 CHAPTER Measuring the Cost of Living  In this chapter, we will discuss What is the Consumer Price Index (CPI)? How is it calculated? What’s it used for? What are the problems with the CPI? How does the CPI differ from the GDP deflator? How can we...

11 CHAPTER Measuring the Cost of Living  In this chapter, we will discuss What is the Consumer Price Index (CPI)? How is it calculated? What’s it used for? What are the problems with the CPI? How does the CPI differ from the GDP deflator? How can we use the CPI to compare dollar amounts from different years? How can we correct interest rates for inflation? © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Consumer Price Index (CPI)  measures the typical consumer’s cost of living  the basis of cost of living adjustments (COLAs) in many contracts and in Social Security How the CPI Is Calculated 1. Fix the “basket.” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 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. How the CPI Is Calculated 4. Choose a base year and compute the index. The CPI in any year equals cost of basket in current year 100 x cost of basket in base year 5. Compute the inflation rate. The percentage change in the CPI from the preceding period. Inflation CPI this year – CPI last year = x 100% rate CPI last year EXAMPLE basket: {4 pizzas, 10 lattes} price of price of year cost of basket pizza latte 2020 $10 $2.00 $10 x 4 + $2 x 10 = $60 2021 $11 $2.50 $11 x 4 + $2.5 x 10 = $69 2022 $12 $3.00 $12 x 4 + $3 x 10 = $78 Compute CPI in each year using 2020 base year: 2020: 100 x ($60/$60) = 100 115 – 100 15% = x 100% 100 2021: 100 x ($69/$60) = 115 130 – 115 2022: 100 x ($78/$60) = 130 13% = x 100% 115 EXAMPLE basket: {4 pizzas, 10 lattes} price of price of year cost of basket pizza latte 2020 $10 $2.00 $10 x 4 + $2 x 10 = $60 2021 $11 $2.50 $11 x 4 + $2.5 x 10 = $69 2022 $12 $3.00 $12 x 4 + $3 x 10 = $78 Compute CPI in each year Inflation rate: 2020: 100 x ($60/$60) = 100 115 – 100 15% = x 100% 100 2021: 100 x ($69/$60) = 115 130 – 115 2022: 100 x ($78/$60) = 130 13% = x 100% 115 ACTIVE LEARNING 1 Calculate the CPI price price of CPI basket: of beef chicken {10 lbs beef, 2020 $4 $4 20 lbs chicken} 2021 $5 $5 The CPI basket cost $120 in 2020, the base year. 2022 $9 $6 A. Compute the CPI in 2021. B. What was the CPI inflation rate from 2021–2022? ACTIVE LEARNING 1 Answers price price of CPI basket: of beef chicken {10 lbs beef, 2020 $4 $4 20 lbs chicken} 2021 $5 $5 The CPI basket cost $120 in 2020, the base year. 2022 $9 $6 A. Compute the CPI in 2021: Cost of CPI basket in 2021 = ($5 x 10) + ($5 x 20) = $150 CPI in 2021 = 100 x ($150/$120) = 125 ACTIVE LEARNING 1 Answers price price of CPI basket: of beef chicken {10 lbs beef, 2020 $4 $4 20 lbs chicken} 2021 $5 $5 The CPI basket cost $120 in 2020, the base year. 2022 $9 $6 B. What was the inflation rate from 2021–2022? Cost of CPI basket in 2022 = ($9 x 10) + ($6 x 20) = $210 CPI in 2022 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40% What’s in the CPI’s Basket? Problems with the CPI – 1 Substitution bias: When prices increase disproportionately consumers substitute toward less expensive goods. This substitution is not captured by CPI because of its fixed basket  Problems with the CPI – 1 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.  Problems with the CPI – 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.  Problems with the CPI – 3 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.  Thus, the CPI overstates increases in the cost of living.  Problems with the CPI  Each of these problems causes the CPI to overstate cost of living increases.  The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year.  This is important because Social Security payments and many contracts have COLAs tied to the CPI.  Two measures of inflation, 1965–2022 Mankiw, Principles of Macroeconomics, 10th 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.  Contrasting the CPI and GDP Deflator Imported consumer goods:  included in CPI  excluded from GDP deflator Capital goods:  excluded from CPI  included in GDP deflator The basket: (if produced domestically)  CPI uses fixed basket  GDP deflator uses basket of currently produced goods & services  ACTIVE LEARNING 3 CPI vs. GDP deflator In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C. Armani raises the price of the Italian jeans it sells in the U.S. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  ACTIVE LEARNING 3 Answers A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Correcting Variables for Inflation: Comparing Dollar Figures from Different Times  Inflation makes it harder to compare dollar amounts from different times.  Example: the minimum wage  $1.25 in Dec 1963  $7.25 in Jan. 2024  Did min wage have more purchasing power in Dec 1963 or Jan. 2024?  To compare, use CPI to convert 1963 figure into “2024 dollars”…  Correcting Variables for Inflation: Comparing Dollar Figures from Different Times Amount Amount Price level today in today’s = in year T x dollars dollars Price level in year T  In our example,  “year T ” is 12/1963, “today” is 01/2024  Min wage was $1.25 in year T  CPI = 30.9 in year T, CPI = 308 today The minimum wage 308 in 1963 was $9.75 $12.5 = $1.25 x 30.9 in 2024 dollars. Note: the ratio of price levels = 240.9/30.9 = 10. This means that the cost of living has increased by a factor of 10. We multiply this factor by the 1963 wage figure to convert the latter into “today’s dollars.” Interpreting the result: The $1.25 minimum wage in December 1963 could have purchased $12.5 worth of goods and services if prices in 1963 were the same as they were in January 2024. 23 Purchasing Power Calculator: http://www.buyupside.com/calculat ors/purchasepowerjan08.htm 24  Correcting Variables for Inflation: Comparing Dollar Figures from Different Times  Researchers, business analysts, and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures.  They can then see how a variable has changed over time after correcting for inflation.  Example: the minimum wage…  The U.S. Minimum Wage in Current Dollars and Today’s Dollars, 1960–2024 Additional reading on the history of the minimum w age  A C T I V E L E A R N I N G 4 : Comparing tuition increases Tuition and Fees at U.S. Colleges and Universities 1990 2022 Private non-profit 4-year $9,340 $38,070 Public 4-year (in state) $1,908 $10,740 Public 2-year $906 $3,800 CPI 130.7 292.3 A. Express the 1990 tuition figures in 2022 dollars, then compute the percentage increase in real terms for both types of schools. B. Which type experienced the largest increase in real tuition costs?  A C T I V E L E A R N I N G 4: Answers 1990 2022 % change CPI 130.7 292.3 123.6% Private non-profit 4-year (current $) $9,340 $38,070 Private non-profit 4-year (in 2022 $) $20,888 $38,070 82.3% Public 4-year (in state, current $) $1,908 $10,740 Public 4-year (in state, in 2022 $) $4,267 $10,740 151.7% Public 2-year (current $) $906 $3,800 Public 2-year (in 2022 $) $2,026 $3,800 87.5% © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. 29 Mankiw, Principles of Macroeconomics, 10th 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.  Real and Nominal Interest Rates The nominal interest rate: – Interest rate not corrected for inflation – Rate of growth in the dollar value of a deposit or debt The real interest rate: – Corrected for inflation – Rate of growth in the purchasing power of a deposit or debt Real interest rate = = (nominal interest rate) – (inflation rate) 30 Mankiw, Principles of Macroeconomics, 10th 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. Example 3: Real vs. nominal interest rates Amir received a $1,000 end-of-year bonus at his job. He deposits the $1,000 in his savings account for one year. The nominal interest rate is 9%. During that year, inflation is 3.5%. At the end of the year, is Amir able to buy more or fewer goods with his money? How much? Real interest rate = Nominal interest rate – Inflation = 9.0% – 3.5% = 5.5% The purchasing power of the $1,000 deposit has grown by 5.5%. Mankiw, Principles of Macroeconomics, 10th 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. 31  Real & nominal interest rates, the U.S., 1965–2022 Real Nominal Interest rate (percent per year) Mankiw, Principles of Macroeconomics, 10th 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. 32  Summary The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer’s “basket” of goods & services. The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.