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Introduction to Macroeconomics
Chapter 11
Measuring the Cost of Living
Inflation, CPI, and Prices
Cost of Living
• Another measure of what is happening in the
economy is the cost of living
• Prices of many goods and services change in
different directions – some increase, some
decrease, some stay the same
• When the majority of prices increase – inflation!
Use a price index to measure overall prices in an
economy
The Consumer Price Index (CPI)
• Measures the typical consumer’s cost of living
• CPI is made up of a fixed basket of goods
whose prices change year over year
• The change in prices for the basket of goods
indicates inflation
How the CPI Is Calculated
1. Fix the “basket.”
Determine what goods make it into the basket
Quantity of goods remains constant
2. Find the prices.
Determine the prices of each good
Prices change
3. Compute the basket’s cost.
Cost of the basket = number of goods in basket x
price of each good
How the CPI Is Calculated
4. Choose a base year and compute the index.
CPI =
Cost of basket in current year
Cost of basket in base year
X 100
5. Compute the inflation rate.
Inflation
=
rate
CPI this year – CPI last year
x 100%
CPI last year
Application 1
Consider an economy where the typical consumer
consumes 10 lbs. of beef and 20 lbs. of chicken.
These are the two goods in the CPI basket.
price of beef
price of chicken
2010
$4
$4
2011
$5
$5
2012
$9
$6
• What is the CPI each year if the base year is 2010?
• What is the inflation rate in 2011 and 2012?
Application 1
$80
Cost of the
Basket
$120
100
$50
$100
$150
125
$90
$120
$210
175
PxQ Beef
PxQ Chicken
2010
$40
2011
2012
Inflation:
2010 - 2011: (125 – 100)/100 = 25%
2011 – 2012: (175 – 125)/100 = 40%
CPI
What’s in the CPI’s Basket?
Food and bev.
7.0%
17.0%
6.0%
Housing
7.0%
Apparel
4.0%
3.0%
Transportation
Medical care
Recreation
Education and
communication
Other goods
and services
15.0%
41.0%
Finding Inflation Data
• Go to http://databank.worldbank.org/data/home.aspx
• Click on “World Development Indicators”
– Choose 4-5 countries from the list
– In series – Choose Inflation
– In Time – Choose 2000 – 2015 (or recent 15 years)
• Download the data
– Download option  Excel
• Open Excel File
– Copy data  paste in new sheet (Transpose)
– Add Year column in Column A
– Create a line graph
• What do you observe from your data? What has been happening
with prices in these economies?
Prices across time
• We can adjust prices for inflation to compare value across
time:
 
  =   ∗
 
• Example:
–
–
–
–
Cost of bread in 1960: $0.60
CPI 1960: 29.6
CPI 2015: 237.1
Cost of 1960’s bread today: $0.60* (237.1/29.6) = $4.80
Application
• Pick a typical consumer good you purchase frequently.
• Find an estimate of the price of that in 1940, 1960, 1980,
2000.
• What is the value of that good in 2015 dollars? Is it more or
less expensive today?
• What implication does this have on today’s standard of living
compared to the standard of living in the past?
Problems with CPI
CPI can overstate inflation because of:
• Substitution Bias
When eggs become more expensive, consumers will buy other breakfast
products and buy less eggs. This adjustment in quantity is not always taken
into account in the cost of the basket.
• Introduction of New Goods
New goods increase the variety of products available to satisfy a consumer’s
needs and wants, making each dollar “more valuable”. Without including new
goods, CPI misses out on this effect.
• Unmeasured Quality Changes
Improvements in products again increase the value of each dollar, because
you get more for each dollar spent. Without accounting for it, cost of living is
overstated.
Costs of Inflation
•
•
•
•
Menu costs
Shoe-leather costs
Drop in purchasing power
General confusion and inconvenience
Key Takeaways
• The CPI shows the cost of a basket of goods and
services that most consumers purchase.
• Though imperfect, it provides a decent reflection
on the cost of living in a country and how it
changes
• With the price index (CPI or GDP deflator) we can
calculate inflation and adjust for the value of
goods overtime