WHAT’S NEW IN THE EIGHTH EDITION:
A new key term, core CPI, and a new Case Study on “Regional Dierences in the Cost of
Living” have been added.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
how the consumer price index (CPI) is constructed.
why the CPI is an imperfect measure of the cost of living.
how to compare the CPI and the GDP de*ator as measures of the overall price level.
how to use a price index to compare dollar +gures from dierent times.
the distinction between real and nominal interest rates.
CONTEXT AND PURPOSE:
Chapter 24 is the second chapter of a two-chapter sequence that deals with how economists
measure output and prices in the macroeconomy. Chapter 23 addressed how economists
measure output. Chapter 24 develops how economists measure the overall price level in the
macroeconomy.
The purpose of Chapter 24 is twofold: +rst, to show students how to generate a price
index and, second, to teach them how to employ a price index to compare dollar +gures
from dierent points in time and to adjust interest rates for in*ation. In addition, students
will learn some of the shortcomings of using the consumer price index as a measure of the
cost of living.
KEY POINTS:
The consumer price index (CPI) shows the cost of a basket of goods and services relative
to the cost of the same basket in the base year. The index is used to measure the overall
level of prices in the economy. The percentage change in the CPI measures the in*ation
rate.
400
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in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
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24 MEASURING THE COST
OF LIVING
401 ❖ Chapter 24/Measuring the Cost of Living
The CPI is an imperfect measure of the cost of living for three reasons. First, it does not
take into account consumers’ ability to substitute toward goods that become relatively
cheaper over time. Second, it does not take into account increases in the purchasing
power of the dollar due to the introduction of new goods. Third, it is distorted by
unmeasured changes in the quality of goods and services. Because of these
measurement problems, the CPI overstates true in*ation.
Like the CPI, the GDP de*ator measures the overall level of prices in the economy. The
two price indexes usually move together, but there are important dierences. The GDP
de*ator diers from the CPI because it includes goods and services produced rather than
goods and services consumed. As a result, imported goods aect the CPI but not the GDP
de*ator. In addition, while the CPI uses a +xed basket of goods, the GDP de*ator
automatically changes the group of goods and services over time as the composition of
GDP changes.
Dollar +gures from dierent times do not represent a valid comparison of purchasing
power. To compare a dollar +gure from the past to a dollar +gure today, the older +gure
should be in*ated using a price index.
Various laws and private contracts use price indexes to correct for the eects of in*ation.
The tax laws, however, are only partially indexed for in*ation.
A correction for in*ation is especially important when looking at data on interest rates.
The nominal interest rate is the interest rate usually reported; it is the rate at which the
number of dollars in a savings account increases over time. By contrast, the real interest
rate takes into account changes in the value of the dollar over time. The real interest
rate equals the nominal interest rate minus the rate of in*ation.
CHAPTER OUTLINE:
I. The Consumer Price Index
A. De+nition of consumer price index (CPI): a measure of the overall cost of the
goods and services bought by a typical consumer.
B. How the CPI Is Calculated
1. Fix the basket.
a. The Bureau of Labor Statistics uses surveys to determine a representative
bundle of goods and services purchased by a typical consumer.
b. Example: 4 hot dogs and 2 hamburgers.
2. Find the prices.
a. Prices for each of the goods and services in the basket must be determined
for each time period.
b. Example:
Year Price of Hot
Dogs
Price of
Hamburgers
2016 $1 $2
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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 or school-approved learning management system for classroom use.
Table 1
Chapter 24/Measuring the Cost of Living ❖ 402
2017 $2 $3
2018 $3 $4
3. Compute the basket’s cost.
a. By keeping the basket the same, only prices are being allowed to change. This
allows us to isolate the eects of price changes over time.
b. Example:
Cost in 2016 = ($1 × 4) + ($2 × 2) = $8.
Cost in 2017 = ($2 × 4) + ($3 × 2) = $14.
Cost in 2018 = ($3 × 4) + ($4 × 2) = $20.
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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 or school-approved learning management system for classroom use.
ALTERNATIVE CLASSROOM EXAMPLE:
Using the example from Chapter 10:
1. Fix the basket: 3 footballs and 4 basketballs.
2. Find the prices:
Year Price of
Footballs
Price of
Basketballs
Year 1 $10 $12
Year 2 12 15
Year 3 14 18
3. Compute the Cost of the Basket:
Cost in Year 1 = (3 × $10) + (4 × $12) = $78
Cost in Year 2 = (3 × $12) + (4 × $15) = $96
Cost in Year 3 = (3 × $14) + (4 × $18) = $114
4. Using Year 1 as the base year, compute the index:
CPI in Year 1 = ($78/$78) × 100 = 100
CPI in Year 2 = ($96/$78) × 100 = 123.08
CPI in Year 3 = ($114/$78) × 100 = 146.15
5. Compute the in*ation rate:
In*ation rate for Year 2 = [(123.08 – 100)/100] × 100 = 23.08%
In*ation rate for Year 3 = [(146.15 – 123.08)/123.08] × 100 = 18.74%
It is very important that students understand how to make these
calculations. Students often have a diTcult time recreating the steps
taken in class without the instructor’s help.
403 ❖ Chapter 24/Measuring the Cost of Living
Activity 1—Create a Student Price Index
Type: Take-home assignment
Topics: Consumer price index
Class limitations: Works in any size class
Purpose
This assignment gives students a practical look at how price indices are
measured. It also establishes base prices for calculating in*ation rates later in the
term.
Instructions
The students should pick real transaction prices for goods they actually purchase.
If the indices will be used to calculate in*ation rate, they should save a copy of
this assignment. They should not use prices from catalogs because such prices
will not be subject to much change over the semester.
Points for Discussion
This assignment makes a good introduction to a discussion of market basket
selection for price indices. The goods that students usually pick for their market
basket account for a relatively small portion of consumer spending compared to
housing, medical care, transportation, etc. Ask the students which goods are likely
to change price frequently.
This can be used to introduce problems with the measurement of the consumer
price index.
Assignment
The consumer price index includes the prices of hundreds of goods purchased by
consumers. It is possible to construct many other price indexes.
Your mission: Create a personalized student price index.
1. Choose +ve (or more) dierent products.
— be speci+c e.g., unleaded gasoline, Pepsi
2. Pick a quantity for each product. This will be your market basket.
— e.g., 15 gallons gasoline, 12 pack of Pepsi
3. Find the actual price for each product.
4. Calculate the total cost of buying these products.
At the end of the semester, have students +nd the prices for these same +ve
products and recalculate the cost of their market basket. Then, have the students
4. Choose a base year and compute the index.
a. The base year is the benchmark against which other years are compared.
b. The formula for calculating the price index is:
100
yearbaseinbasketoficePr
yearcurrentinbasketoficePr
CPI
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 or school-approved learning management system for classroom use.
Chapter 24/Measuring the Cost of Living ❖ 404
c. Example (using 2016 as the base year):
CPI for 2016 = ($8)/($8) × 100 = 100.
CPI for 2017 = ($14)/($8) × 100 = 175.
CPI for 2018 = ($20)/($8) × 100 = 250.
5. Compute the in*ation rate.
a. De+nition of in6ation rate: the percentage change in the price index
from the preceding period.
b. The formula used to calculate the in*ation rate is:
100
1
12
2
yearinCPI
yearinCPIyearinCPI
yearinrateInflation
c. Example:
In*ation Rate for 2017 = (175 – 100)/100 × 100 = 75%.
In*ation Rate for 2018 = (250 – 175)/175 × 100 = 43%.
C. Core CPI
1. De+nition of core CPI: a measure of the overall cost of consumer goods
and services excluding food and energy.
2. Because the prices of food and energy are unstable, the core CPI better re*ects
ongoing in*ation trends.
D. The Producer Price Index
1. De+nition of producer price index (PPI): a measure of the cost of a basket
of goods and services bought by 7rms.
2. Because +rms eventually pass on higher costs to consumers in the form of higher
prices on products, the producer price index is believed to be useful in predicting
changes in the CPI.
E. FYI: What is in the CPI’s Basket?
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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 or school-approved learning management system for classroom use.
Be sure to point out to students that it is possible for the CPI to fall if
de*ation is present. Point out to students that, even though they have not
experienced de*ation in their lifetimes, it has occurred during several
periods of U.S. history (especially during the Great Depression).
Make sure that you explain that in*ation does not mean that the prices of
all goods in the economy are rising. In*ation means that prices on
average are rising. In fact, the prices of many electronic goods (such as
computers and DVD players) have fallen over time.
Point out that the CPI must be equal to 100 in the base year.
405 ❖ Chapter 24/Measuring the Cost of Living
1. Figure 1 shows the makeup of the market basket used to compute the CPI.
2. The largest category is housing, which makes up 42% of a typical consumer’s
budget.
F. Problems in Measuring the Cost of Living
1. Substitution Bias
a. When the price of one good changes, consumers often respond by
substituting another good in its place.
b. The CPI does not allow for this substitution; it is calculated using a +xed
basket of goods and services.
c. This implies that the CPI overstates the increase in the cost of living over time.
2. Introduction of New Goods
a. When a new good is introduced, consumers have a wider variety of goods and
services from which to choose.
b. This makes every dollar more valuable, which lowers the cost of maintaining
the same level of economic well-being.
c. Because the market basket is not revised often enough, these new goods are
left out of the bundle of goods and services included in the basket.
3. Unmeasured Quality Change
a. If the quality of a good falls from one year to the next, the value of a dollar
falls; if quality rises, the value of the dollar rises.
b. Attempts are made to correct prices for changes in quality, but it is often
diTcult to do so because quality is hard to measure.
4. The size of these problems is also diTcult to measure.
5. Many economists believe that the CPI overstates the rate of in*ation by
approximately one-half percentage point per year.
6. The issue is important because many government transfer programs (such as
Social Security) are tied to increases in the CPI.
G. In the News: Monitoring Ination in the Internet Age
1. The internet provides dierent ways to collect data on the overall price level.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 or school-approved learning management system for classroom use.
Figure 1
One way to highlight this is to draw the pie chart on the board without the
category names and let the students decide what goes where. Most likely,
they will be surprised by the sizes of recreation and medical care.
Chapter 24/Measuring the Cost of Living ❖ 406
2. This article from Slate describes some new price indices that take advantage of
information available on the web.
H. The GDP De*ator versus the Consumer Price Index
1. The GDP de*ator re*ects the prices of all goods produced domestically, while the
CPI re*ects the prices of all goods bought by consumers.
2. The CPI compares the prices of a xed basket of goods over time, while the GDP
de*ator compares the prices of the goods currently produced to the prices of the
goods produced in the base year. This means that the group of goods and
services used to compute the GDP de*ator changes automatically over time as
output changes.
3. Figure 2 shows the in*ation rate as measured by both the CPI and the GDP
de*ator.
II. Correcting Economic Variables for the Eects of In*ation
A. Dollar Figures from Dierent Times
1. To change dollar values from one year to the next, we can use this formula:
2. Example: Babe Ruth’s 1931 salary in 2015 dollars:
Salary in 2015 dollars = Salary in 1931 dollars ×
Salary in 2015 dollars = $80,000 × (237/15.2).
Salary in 2015 dollars = $1,247,368.
3. FYI: Mr. Index Goes to Hollywood
a. Reports of box oTce success are often made in terms of the dollar values of
ticket sales.
b. These ticket sales are then compared with ticket sales of movies in the past.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
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 or school-approved learning management system for classroom use.
Figure 2
Price level in Year 2
Value in Year 2 dollars Value in Year 1 dollars Price level in Year 1
æ ö
= ´ ç ÷
è ø
ALTERNATIVE CLASSROOM EXAMPLE:
Your father graduated from school and took his +rst job in 1982, which paid a
salary of $15,000. What is this salary worth in 2015 dollars?
CPI in 1982 = 96.5
CPI in 2015 = 237
Value in 2015 dollars = 1982 salary × (CPI in 2015/CPI in 1982)
Value in 2015 dollars = $15,000 × (237/96.5) = $36,839
407 ❖ Chapter 24/Measuring the Cost of Living
c. However, no corrections for changes in the value of a dollar are made.
Activity 2—You Paid How Much?
Type: Take-home assignment
Topics: Consumer price index
Class limitations: Works in any size class
Purpose
This assignment gives students a chance to see how dollar values have changed
over time. It also provides them some practice at using the formula to calculate
changes in dollar values over time.
Instructions
Have students ask their parents (or grandparents) how much they paid for their
+rst car and in what year they bought it. (If there are older students in the class,
ask them to remember how much they paid for their +rst car.) Students can then
determine how much they would have to pay in current dollars using the
consumer price index.
4. Case Study: Regional Di,erences in the Cost of Living
a. The Bureau of Economic Analysis computes regional price parities, which
measure variation in the cost of living from state to state.
b. Prices in services, and particularly housing services, can be persistently large
because services cannot be moved easily.
B. Indexation
1. De+nition of indexation: the automatic correction of a dollar amount for
the e<ects of in6ation by law or contract.
2. As mentioned above, many government transfer programs use indexation for the
bene+ts. The government also indexes the tax brackets used for federal income
tax.
3. There are uses of indexation in the private sector as well. Many labor contracts
include cost-of-living allowances (COLAs).
C. Real and Nominal Interest Rates
1. Example: Sally Saver deposits $1,000 into a bank account that pays an annual
interest rate of 10%. A year later, she withdraws $1,100.
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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 or school-approved learning management system for classroom use.
Use an example to make the importance of real interest rates clear.
Suppose a student has $100 in his savings account earning 3% interest.
Ask students what will happen to the purchasing power of that money if
prices rise 3% during the year. Then, change the in*ation rate to 5% and
then 1% and go through the example again.
Chapter 24/Measuring the Cost of Living ❖ 408
2. What matters to Sally is the purchasing power of her money.
a. If there is zero in*ation, her purchasing power has risen by 10%.
b. If there is 6% in*ation, her purchasing power has risen by about 4%.
c. If there is 10% in*ation, her purchasing power has remained the same.
d. If there is 12% in*ation, her purchasing power has declined by about 2%.
e. If there is 2% de*ation, her purchasing power has risen by about 12%.
3. De+nition of nominal interest rate: the interest rate that measures the
change in dollar amounts.
4. De+nition of real interest rate: the interest rate corrected for in6ation.
5. Case Study: Interest Rates in the U.S. Economy
a. Figure 3 shows real and nominal interest rates from 1965 to the present.
b. The nominal interest rate is always greater than the real interest rate in this
diagram because there was always in*ation during this period.
c. Note that in the late 1970s the real interest rate was negative because the
in*ation rate exceeded the nominal interest rate.
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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 or school-approved learning management system for classroom use.
real interest rate nominal interest rate in*ation rate= –
Figure 3