24,Measuring the Cost of Living,Measuring the Cost of Living,Inflation refers to a situation in which the economys overall price level is rising.The inflation rate is the percentage change in the price level from the previous period.,THE CONSUMER PRICE INDEX,The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. The Bureau of Labor Statistics reports the CPI each month.It is used to monitor changes in the cost of living over time.,THE CONSUMER PRICE INDEX,When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.,How the Consumer Price Index Is Calculated,Fix the Basket: Determine what prices are most important to the typical consumer.The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services.,How the Consumer Price Index Is Calculated,Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.,How the Consumer Price Index Is Calculated,Compute the Baskets Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.,How the Consumer Price Index Is Calculated,Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.,How the Consumer Price Index Is Calculated,Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.,How the Consumer Price Index Is Calculated,The Inflation RateThe inflation rate is calculated as follows:,Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example,Copyright2004 South-Western,Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example,Copyright2004 South-Western,Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example,Copyright2004 South-Western,Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example,Copyright2004 South-Western,Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example,Copyright2004 South-Western,How the Consumer Price Index Is Calculated,Calculating the Consumer Price Index and the Inflation Rate: Another ExampleBase Year is 2002.Basket of goods in 2002 costs $1,200.The same basket in 2004 costs $1,236.CPI = ($1,236/$1,200) 100 = 103.Prices increased 3 percent between 2002 and 2004.,FYI: Whats in the CPIs Basket?,Copyright2004 South-Western,Problems in Measuring the Cost of Living,The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.,Problems in Measuring the Cost of Living,Substitution biasIntroduction of new goodsUnmeasured quality changes,Problems in Measuring the Cost of Living,Substitution BiasThe basket does not change to reflect consumer reaction to changes in relative prices.Consumers substitute toward goods that have become relatively less expensive.The index overstates the increase in cost of living by not considering consumer substitution.,Problems in Measuring the Cost of Living,Introduction of New GoodsThe basket does not reflect the change in purchasing power brought on by the introduction of new products.New products result in greater variety, which in turn makes each dollar more valuable.Consumers need fewer dollars to maintain any given standard of living.,Problems in Measuring the Cost of Living,Unmeasured Quality ChangesIf the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.The BLS tries to adjust the price for constant quality, but such differences are hard to measure.,Problems in Measuring the Cost of Living,The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.The CPI overstates inflation by about 1 percentage point per year.,The GDP Deflator versus the Consumer Price Index,The GDP deflator is calculated as follows:,The GDP Deflator versus the Consumer Price Index,The BLS calculates other prices indexes: The index for different regions within the country.The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.,The GDP Deflator versus the Consumer Price Index,Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising.There are two important differences between the indexes that can cause them to diverge.,