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MACROECONOMICS 1
TOPIC III: Measuring the Cost of Living

CORE CONCEPTS

CPI, CPI calculation

Inflation
GDP deflator vs. CPI
Real vs. Nominal Rate

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THE CONSUMER PRICE INDEX

(CPI)
The Consumer Price Index (CPI) is a measure of the overall
cost of the goods and services bought by a typical
consumer.
The CPI is used to monitor changes in the cost of living over
time.
When CPI rises, the typical family has to spend more dollars
to maintain the same standard of living

HOW CPI IS CALCULATED?

1. Fix the basket: Determine which prices are most important to
the typical consumer.
2. Find the prices: Find the prices of each of the goods and
services in the basket for each point in time.
3. Calculate the baskets cost: Use the data on prices to calculate
the cost of the basket of goods and services at different times.
4. Choose the base year and compute the index: Designate one
year as the base year, making it the benchmark against which
other years are compared.

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CPI CALCULATION

Cost of basket in current year

CPI in any year =

100

Cost of basket in base year

Q1: The first step in measuring CPI is to

A. select the market basket.

B. conduct a monthly survey.
C. collect prices for the basket of goods and services.
D. interview businesses.

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Q2: The consumer price index (CPI):

A. compares the cost of the typical basket of goods consumed in

period 1 to the cost of a basket of goods typically consumed in
period 2.
B. compares the cost in the current period to the cost in a reference
base period of a basket of goods typically consumed in the base
period.
C. measures the increase in the prices of the goods included in GDP.
D. is the ratio of the average price of a typical basket of goods to the
cost of producing those goods.
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Q3: If the basket of goods and services used to calculate

the CPI cost $200 in the reference base period and $450
in a later year, the CPI for the latter year equals

A. 200
B. 225
C. 325
D. 450

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CPI CALCULATION
Fixed basket of 4 apples and 2 burgers
YEAR

PRICE OF APPLES

PRICE OF BURGERS

2012

$1

$2

2013

$2

$3

2014

$3

$4

YEAR

COST of BASKET

2012
2013
2014
YEAR

CPI (2012 is the base year)

2012
2013
2014

CHANGE IN CPI BASKET

OVERTIME

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INFLATION RATE

The inflation rate is the percentage change in the price

index from the preceding period.

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 inflation rate is calculated as follow:

CPI year 2 - CPI year 1

Inflation rate year 1 =

CPI year 1

X 100

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INFLATION RATE USING CPI

CPI
(2012: BASE
YEAR)

INFLATION
RATE

2012

2013

2014

INFLATION BY COUNTRY

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WORRYING SIGNS: INFLATIONS LIFT AGAIN AS

FRUIT AND VEGETABLE PRICES RISE
1. What was Australia's annual inflation rate in February
2014?
2. What is inflation?
3. How is inflation measured?

ISSUES 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 include:
Substitution bias
Introduction of new goods
Unmeasured quality changes
Those problems listed above change that causes 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.

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ISSUES IN
MEASURING THE COST OF LIVING

Substitution bias: The 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.

ISSUES IN
MEASURING THE COST OF LIVING
Introduction of new goods: The 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.

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ISSUES IN
MEASURING THE COST OF LIVING
Unmeasured quality changes:
If 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.

Q4: If consumers purchase fewer of products that

increase most in price and more of products that
decrease in price as compared to the CPI basket, then:

A. changes in the CPI understates the true rate of inflation

B. changes in the CPI are unrelated to the true rate of inflation
C. changes in the CPI accurately reflect the true rate of
inflation
D. changes in the CPI overstate the true rate of inflation
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GDP DEFLATOR VS. CPI

Economists and policymakers monitor both the GDP deflator
and the CPI to gauge how quickly prices are rising.
There are two important differences between the indexes
that can cause them to diverge.
GDP DEFLATOR

CPI

reflects the prices of all goods

reflects the prices of all goods and
and services produced domestically, services bought by customers
compares the price of currently
produced goods and services to
the price of the same goods and
services in the base year.

compares the price of a fixed

basket of goods and services to the
price of the basket in the base year

CORRECTING ECONOMICS VARIABLES

FOR THE EFFECT OF INFLATION
Price indexes are used to correct for the effects of inflation when
comparing dollar figures from different times.
When some dollar amount is automatically corrected for inflation
by law or contract, the amount is said to be indexed for inflation.
For example; we can find the 2008 purchasing power equivalent
of a $20,000 salary in 1980. We use the following formula:
CPI in 2008

Value in 2008 dollars =

X
CPI in 1980

Value in 1980
dollars

189

X $20,000

82

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REAL VS. NOMINAL INTEREST

RATE
Interest represents a payment in the future for a transfer
of money in the past
NOMINAL INTEREST RATE

is the interest rate usually

reported and not corrected for
inflation. Its the interest rate
that a bank says.

REAL INTEREST RATE

is the nominal interest rate

that is corrected for the effects
of inflation.
nominal interest rate inflation

For e.g.: you borrow some money for 1year, nominal interest
rate is 15%, inflation is 10% => real interest rate = 15% - 10% =
5%

Q5: The CPI in 2011 was 120, CPI in 2012 was 132. A
person borrowed money from the bank in 2011 and
repaid the loan in 2012. If the bank offered the interest
rate on the loan as 12%, what was the real interest
rate?

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Q6: Which of the following is a TRUE statement

about real and nominal GDP?
A. If nominal GDP increases from one year to the next, we know
that production of goods and services has risen.
B. Increases in average prices do not affect the calculation of
nominal GDP.
C. If real GDP increases from one year to the next, we know that
production of goods and services has risen.
D. Nominal GDP is a better measure than real GDP in comparing
changes in the production of goods and service year after year.
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CONSUMER PRICES UP 0.5% AS

FRUIT PRICES SURGE
1. Which categories of prices increased in the September
quarter? Which categories of prices decreased in the
September quarter?
2. How is the CPI measured?
3. What is the relationship between the CPI and the inflation
rate?
4. Could the inflation rate of 0.5% be a biased measure? Why
or why not?

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SUMMARY
The CPI shows the cost of a basket of goods and services relative
to the cost of the same basket in the base year.
The percentage change in the CPI measures the inflation rate.
The CPI is an imperfect measure of the cost of living for the
following three reasons: substitution bias, the introduction of new
goods and unmeasured changes in quality.
Because of measurement problems, the CPI overstates annual
inflation.

SUMMARY
GDP deflator differs from the CPI because it includes goods
and services produced rather than goods and services
consumed.
Dollar figures from different points in time do not represent a
valid comparison of purchasing power.
Various laws and private contracts use price indexes to
correct for the effects of inflation.
Real interest rate = Nominal interest rate - Inflation rate

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