1

MacroLecture4
The Consumer Price Index and the Cost of
Living
Lecture Highlights
Explain what the Consumer Price Index
(CPI) is and how it is calculated
Explain the limitations of the CPI and
describe other measures of the price level
Adjust money values for inflation and
calculate real wage rates and real interest
rates
2
The Consumer Price Index
(CPI)
A measure of the average of the prices
paid by urban consumers for a fixed
market basket of consumer goods and
services
The CPI is defined to equal 100 for a
period called the reference base period
3
Constructing the CPI
Constructing the CPI is a huge operation
that costs millions of dollars and involves
three stages
Selecting the CPI basket
Conducting the monthly price survey
Calculating the CPI
4
Contd.
The CPI basket select the CPI basket. Contains the
goods and services represented in the index and the
relative importance attached to each of them.
The monthly price survey each month the Dept. of
Statistics check the prices of goods and services in the
CPI basket.
because the CPI aims to measure price changes the
prices recorded each month refer to exactly the same
good/ item.
e.g. the price of a jelly beans has increased but a box now
contains more beans. Has the price of a jelly increased?
The survey must record the details of changes in quality,
size, weight or packaging so that prices changes can be
isolated from other changes.
5
Calculating the CPI
The CPI calculation has 3 steps:
(i) Find the cost of the CPI basket at base
period prices.
(ii) Find the cost of the CPI basket at current
period prices.
(iii) Calculate the CPI for the base period
and the current period.
6
Contd.
Suppose the CPI basket contains only two goods
and services oranges & haircuts.
(a) The cost of the CPI basket at base period
prices: 2000
item qty P cost of CPI basket
__________________________________
oranges 10 $1 each $10
Haircuts 5 $8 each $40
Cost of CPI at base period prices $50
7
Contd.
(b) The cost of the CPI basket at current
period prices: 2003
Item qty P cost of CPI basket
__________________________________
Oranges 10 $2 $20
Haircuts 5 $10 $50
Cost of CPI basket at current period prices $70
8
Contd.
Find the CPI for 2000 and 2003
CPI = cost of CPI basket at current period prices
___________________________________ X 100
cost of CPI basket at base period prices
CPI in 2000 = 50
___ X 100 = 100
50
CPI in 2003 = 70
__ X 100 = 140
50
9
Measuring inflation
CPI is used to measure changes in the cost of
living and in the value of money.
To measure these changes, we calculate the
inflation rate the percentage change in the
price level from one year to the next.
Inflation rate = CPI in current year CPI in previous year
________________________________ X 100
CPI in previous year
e.g. the current yaer 2003 CPI 2003 = 140
the previous year 2003 CPI 2002 = 120
inflation rate in 2003 = 140 120
________ X 100 = 16.7%
120
10
The CPI and the Cost of Living
CPI a cost of living index.
The purpose of a cost of living index is to measure changes in the
amount of money that people would need to spend to achieve a
given standard of living.

The CPI does not measure the cost of living for 2 reasons:
(i) The CPI does not try to measure all the components of the cost of
living e.g. a severe winter cause people to buy more natural gas
and electricity to heat their homes. An increase in the prices of
these items would increase the CPI, but the increased quantities
bought would not change the CPI because the CPI basket is fixed.

(i) Components of the cost of living that are measured by the CPI are
not always measured accurately the CPI is a biased measure of
changes in the cost of living.
11
The Biased CPI
New good bias
Quality change bias
Commodity substitution bias
Outlet substitution bias
12
Contd.
New good bias new products replacing the old
ones e.g. the PC has replaced the typewriter,
the DVD is replacing the videocassette player.
If you want to compare the price in 2003 with that
in 1993, you must compare the price of a DVD
today with that of a videocassette player in 1993.
Because DVDs do a better job than videocassette
players, you are better off with the new
technology if the prices were the same. But
DVDs are more expensive than videocassette
players. How much of the higher price is a sign
of the higher quality?
13
Contd.
Quality change bias cars, CD players,
cameras, and many other items get better
every year e.g. central locking, airbags,
and ABS all add to the quality of a car.
They also add to the cost.
Is the improvement in quality greater than
the increase in cost?
A price rise is a payment for improved
quality it is not inflation.
14
Contd.
Commodity substitution bias changes in relative prices
i.e. consumers to change the items they buy.
People buy less on items that become relatively more
costly increase their consumption of items that become
relatively less costly e.g. when the price of beef and
the price of chicken remains constant, you buy more
chicken and less beef.
Suppose that you switch from beef to chicken spend the
same amount on meat as before and get the same
enjoyment as before.
The cost of meat has not changed. But the CPI shows that
the price of meat has increased.
15
Contd.
Outlet substitution bias with higher prices
people use discount store more frequently and
convenience stores less frequently. E.g. gas
prices rise by 10 cents/gallon. Instead of buying
from your nearby gas station for $1.50/gallon,
you now drive farther to a gas station that
charges $1.40/gallon.
Your cost of gas has not increased by as much as
the 10 cents/gallon. However, the CPI says that
the price of gas has increased by 10 cents/
gallon.
16
Two consequences of the CPI
bias
It distorts private contracts
It increases government outlays
Distortion of private contracts many wage contracts
contain a cost of living adjustment.
Suppose a trade union and XYZ corporation agree on
wage rate of $28/hour that increases over 3 years at a
rate of 2%/ year plus the increase in the cost of living.
Suppose that over the 3 years, the CPI increases by 3%
each year, but the true price increase is 1.9%/year (1.1%
point bias in the CPI).
The gap between the actual and intended wage rate the
wage bias.
17
Contd.
Fixed
increas
e
(%)
CPI
increas
e
Wage
rate
($/hr)
True
price
increas
e
Intende
d wage
rate
($/hr)
Wage
bias
($/hr)
Initially
After 1
year
After 2
years
After 3
years

2

2
2

3

3
3
28.00
29.40

30.87
32.41

1.9

1.9
1.9
28.00
29.09

30.23
31.40

0.31

0.64
1.01
18
Contd.
At the end of the 1
st
year, the wage rate
rises by 5% to 29.40 = 28 X 1.05
The intention of the contract was it to
increase by 3.9% to 29.09 = 28 X 1.039
Wage bias after 1 year = 29.40 29.09 =
0.31
19
Contd.
Increases in government outlays
because rising prices decreases the
buying power of the dollar, the CPI is used
to adjust the incomes of many sectors or
groups.
20
Alternative measures of the price
level
PPI (Producer Price Index) the same as CPI, but the
goods in its composition are goods that are paid by
producers of goods.
GDP deflator the most comprehensive price index. It
includes all of the goods and services produced
weighted by their relative values, as a fraction of GDP.
The PCE deflator is an average of the current prices of
the goods and services included in the consumption
expenditure component of GDP expressed as a
percentage of base-year prices.
21
Nominal and Real Values
In 2002, it cost 37 cents to mail a first
class letter. 100 years earlier, in 1902 that
same letter would have cost 2 cents to
mail. Does it really cost you 18.5 times the
amount that it cost your great-grandmother
to mail a letter?
22
Dollars and cents at different
dates
To compare dollar amounts at different
dates, we need to know the CPI at those
dates.
Formula:
Price of good in year B dollars
= price of good in year A dollars X CPI in year B
__________
CPI in year A
23
Contd.
E.g. In 2002, the CPI was 180.3, and in 1902, it
was 9.
Price of stamp in 2002 dollars
= price of stamp in 1902 X CPI in 2002
_________
CPI in 1902
= 2 cents X 180.3
_____ = 40 cents
9
It cost your great-grandmother more to mail that 1
st

class letter than it cost you in 2002.
24
Nominal and Real wage Rates
Nominal wage rate the average hourly wage rate
measured in current dollars.
Real wage rate the average hourly wage rate
measured in the dollars of a given reference
base year.
e.g. In June 2002, the nominal wage rate of
production workers was $14.68 and the CPI was
179.9.
Real wage rate in June 2002 = 14.68
_____ X 100 = $8.16
179.9
25
Nominal and Real Interest
Rates
Nominal interest rate the percentage
return on a loan, calculated by using
dollars.
Real interest rate the percentage return
on a loan, calculated by using purchasing
power the nominal interest rate adjusted
for the effects of inflation.
Real interest rate = nominal interest rate inflation rate
26
Contd.
e.g. Suppose that you have $100 in a bank
account and that after 1 year, you take
your money out of the bank. The bank
pays you the $100 + $5 interest (at 5% a
year). During the year, prices have
increased by 3 %. Youve now got $105,
but you need $103 to buy what $100 at the
time when you put your money in the
bank. You have earned $2 real interest
rate = 2%.