Download Consumer Price Index & Inflation

The CPI and the
Cost of Living
CHAPTER
6
THE CONSUMER PRICE INDEX
What is meant by inflation? Why is it important?
Defn: The rate of inflation is the percentage change in the general
price level from one period to the next.
Defn: Consumer Price Index (CPI) is a measure of the average of
the prices paid by urban consumers for a fixed market basket of
consumer goods and services.
Calculating CPI
1) Identify the market basket
2) Find the prices of each good
3) Compute the cost of the basket
4) Use the basket cost in the base year to calculate the index.
THE CONSUMER PRICE INDEX
Fun Fact
Calculating the Inflation Rate
CPI in current year  CPI in previous year
Inflation rate =
CPI in previous year
x 100
Example
If 2006 is the base year.
Quantity
Price ($)
Year
Books
2
30
2006
Cereal
20
2
2006
Books
4
40
2007
Cereal
10
4
2007
1) Calculate the CPI in 2007.
2) Calculate the 2007 inflation rate and interpret the number.
3) What percent of household budget is spent on books in 2007.
Solution
1) Cost of market basket in 2006 =
(2*$30)+(20*$2)= $100
Cost of market basket in 2007 =
(2*$40)+(20*$4)= $160
CPI in 2007=
(160/100)*100= 160
2) 2007 inflation rate = [(CPI in 07-CPI in 06)/CPI in 06 ]*100
n.b Inflation is calculated using the previous year NOT the base year.
inflation=
(160-100)/100 = 60%
Solution contd.
3) Household budget in 2007 = 4*$40+10*$4 = $200
percentage spent on books = ($160/$200)*100= 80%
6.2 THE CPI AND OTHER PRICE LEVEL MEASURES
CPI is not a perfect measure of the C.O.L due to certain biases.
The idea is that we want to compare cost of living over time.
 Sources of Bias in the CPI
The potential sources of bias in the CPI are
•
•
•
•
New goods bias
Quality change bias
Commodity substitution bias
Outlet substitution bias
THE CPI AND OTHER PRICE LEVEL MEASURES
Alternative Measures of the Price Level
1) The GDP deflator
GDP deflator = (Nominal GDP  Real GDP)  100.
The inflation rate can also be calculated using the GDP deflator.
2) The personal consumption expenditures deflator
(PCE deflator)
The PCE deflator is an average of current prices of all the goods
and services included in the consumption expenditure component
of GDP expressed as a percentage of base-year prices.
Idea: Is a subset of the GDP deflator.
NOMINAL AND REAL VALUES
Nominal vs Real Values
Examples
1)Nominal GDP and real GDP (recall)
2)Nominal wage rate and real wage rate
3)Nominal interest rate and real interest rate
Real interest rate = Nominal interest rate – Inflation rate
Converting from nominal to real value
Real value= nominal value/ Price Level (CPI or GDP deflator)
Converting from year T into today’s dollars
Value today= Value in yr T * ( Price level today/ Price level Yr T)
Use of CPI
Three good uses: calculate inflation, calculating the expected price,
calculating real value.
Ex. If CPI in 2007= 150, the CPI in 1995= 120. A Nintendo costs
$200 in 1995. What is the price of a Nintendo in 2007.
Price 07= (price in 95 ) X (CPI 07/ CPI 95)
Price in 07 =$200*1.52 = $250
2)Nominal wage in 2007 was $10/ hr. If 2007 CPI=150, what is the
real wage. i.e the wage in base year price?
Real wage= (nominal value/CPI )*100= ($10/150)*100= $6.667