the 6
Measuring Cost of Living
PRINCIPLES OF
MACROECONOMICS
FOURTH CANADIAN EDITION
N. G R E G O R Y M A N K I W
R O N A L D D. K N E E B O N E
K E N N E T H J. M c K ENZIE
NICHOLAS ROWE
PowerPoint Slides
by Ron Cronovich
Canadian adaptation by Marc PrudHomme
2008 Nelson Education Ltd.
In this chapter, look for the answers to these
questions:
What is the Consumer Price Index (CPI)?
How is it calculated? Whats it used for?
What are the problems with the CPI? How serious are
they?
How does the CPI differ from the GDP deflator?
How can we use the CPI to compare dollar amounts from
different years? Why would we want to do this, anyway?
How can we correct interest rates for inflation?
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The Consumer Price Index (CPI)
Inflation refers to a situation in which the economys
Inflation
overall price level is rising.
The inflation rate is the percentage change in the price
level from the previous period.
The consumer price index (CPI) is a measure of the
consumer
overall cost of the goods and services bought by a
typical consumer.
Statistics Canada reports the CPI each month.
It is used to monitor changes in the cost of living over
time.
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How the CPI Is Calculated
Determine the Basket: Determine what prices are
most important to the typical consumer.
If the typical consumer buys more hot dogs than
hamburgers, then the price of hot dogs is more
important and is given more weight in measuring the
cost of living.
Statistics Canada sets these weights by surveying
consumers to find out the basket of goods the
typical consumer buys
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How the CPI Is Calculated
Find the Prices: Find the prices of each of the goods
and services in the basket for each point in time.
Compute the Baskets Cost: Use the data on prices
to calculate the cost of the basket of goods and
services at different times.
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How the CPI Is Calculated
Choose a Base Year and Compute the Index:
Choose
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.
cost of basket in current year
100 x
cost of basket in base year
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= CPI
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How the CPI Is Calculated
Compute the inflation rate.
The percentage change in the CPI from the preceding
period.
inflation
=
rate
CPI this year CPI last year
CPI last year
x 100%
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EXAMPLE
basket: {4 pizzas, 10 lattes}
year
price of
pizza
price of
latte
2004
$10
$2.00
$10 x 4 + $2 x 10
2005
$11
$2.50
$11 x 4 + $2.5 x 10 = $69
2006
$12
$3.00
$12 x 4 + $3 x 10
cost of basket
Compute CPI in each year:
= $78
Inflation rate:
2004: 100 x ($60/$60) = 100
= $60
15%
2005: 100 x ($69/$60) = 115
13%
2006: 100 x ($78/$60) = 130
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ACTIVE LEARNING
Calculate the CPI
Calculate
The basket contains
20 movie tickets
and 10 textbooks.
The table shows their
prices for 2004-2006.
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
The base year is 2004.
A. How much did the basket cost in 2004?
B. What is the CPI in 2005?
C. What is the inflation rate from 2005-2006?
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ACTIVE LEARNING
Answers
Answers
The basket contains
20 movie tickets
and 10 textbooks.
A. How much did
the basket cost in
2004?
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
($10 x 20) + ($50 x 10) = $700
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ACTIVE LEARNING
Answers
Answers
The basket contains
20 movie tickets
and 10 textbooks.
B. What is the CPI
in 2005?
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
cost of basket in 2005
= ($10 x 20) + ($60 x 10) = $800
CPI in 2005 = 100 x ($800/$700) = 114.3
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ACTIVE LEARNING
Answers
Answers
The basket contains
20 movie tickets
and 10 textbooks.
C. What is the
inflation rate from
2005-2006?
1:
movie
tickets
textbooks
2004
$10
$50
2005
$10
$60
2006
$12
$60
cost of basket in 2006
= ($12 x 20) + ($60 x 10) = $840
CPI in 2006 = 100 x ($840/$700) = 120
Inflation rate = (120 114.3)/114.3 = 5%
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FYI: Whats in the CPIs Basket?
Recreation,
education and
reading
12%
Alcoholic
beverages and
tobacco
products
3%
Food
17%
Health and
personal care
5%
Transportation
20%
Shelter
27%
Clothing and
footwear
5%
Household
operations and
furnishings
11%
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How the CPI Is Calculated
Statistics Canada computes many other indexes
CPI for each province
For 16 cities
Food
Clothing
Core inflation: Measure of the underlying trend in
inflation.
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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.
Three problems with the index are widely acknowledged
but difficult to solve
Substitution bias
Introduction of new goods
Unmeasured quality changes
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Problems With the CPI:
Substitution Bias
Over time, some prices rise faster than others.
Consumers substitute toward goods that become
relatively cheaper.
The CPI misses this substitution because it uses a fixed
basket of goods.
Thus, the CPI overstates increases in the cost of living.
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Problems With the CPI:
Introduction of New Goods
When new goods become available,
variety increases, allowing consumers to find products
that more closely meet their needs.
This has the effect of making each dollar more
valuable.
The CPI misses this effect because it uses a fixed
basket goods.
Thus, of the CPI overstates increases in the cost of living.
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Problems With the CPI:
Unmeasured Quality Change
Improvements in the quality of goods in the basket
increase the value of each dollar.
Statistics Canada tries to account for quality changes,but
probably misses some quality improvements, as quality
is hard to measure.
Thus, the CPI overstates increases in the cost of living.
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Problems With the CPI
Each of these problems causes the CPI to overstate cost
of living increases.
Statistics Canada has made technical adjustments, but
the CPI probably still overstates inflation by about 0.5
percent per year.
This is important, because many government programs
and many contracts have COLAs tied to the CPI.
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The GDP Deflator versus the Consumer Price
Index
The GDP deflator
reflects the current level of prices relative to the level of
prices in the base year.
is monitored by economists to gauge how quickly
prices are rising
is calculated as follows:
GDP deflator =
Nominal GDP
100
Real GDP
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Contrasting the CPI and GDP Deflator
Imported consumer goods:
Imported consumer goods:
included in CPI
included in CPI
excluded from GDP deflator
excluded from GDP deflator
Capital goods:
Capital goods:
excluded from CPI
excluded from CPI
included in GDP deflator (if
included in GDP deflator (if
produced domestically)
produced domestically)
The basket:
The basket:
CPI uses fixed basket
CPI uses fixed basket
GDP deflator uses basket of
GDP deflator uses basket of
currently produced goods & services
currently produced goods & services
This matters if different prices are
This matters if different prices are
changing by different amounts.
changing by different amounts.
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Contrasting the CPI and GDP Deflator
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ACTIVE LEARNING
CPI vs. GDP deflator
CPI
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2:
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Canadian Machinery Corp. raises the price of its
precision tools it manufactures at its Kitchener plant.
C. Armani raises the price of the Italian jeans it sells in
Canada
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ACTIVE LEARNING
Answers
Answers
2:
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Canadian Machinery Corp. raises the price of its
precision tools it manufactures at its Kitchener plant.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it sells in the
U.S.
The CPI rises, the GDP deflator does not.
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CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
Price indexes are used to correct for the effects of
inflation when comparing dollar figures from different
times.
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Comparing Dollar Figures from Different Times
Inflation makes it harder to compare dollar amounts from
different times.
We can use the CPI to adjust figures so that they can be
compared.
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EXAMPLE: The High Price of Gasoline
Do the following to convert (inflate) the price of gas in
1957 to dollars in 2003:
1957 gas price in 1997 dollars
= 1957 gas price x
CPI in 2003
CPI in 1957
= 9.5 cents x (122/17.6)
= 65.8 cents
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ACTIVE LEARNING
Exercise
Exercise
3:
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000
Are econ majors better off today or in 1980?
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ACTIVE LEARNING
Answers
Answers
3:
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000
Solution
Convert 1980 salary into todays dollars
$24,000 x (180/90) = $48,000.
After adjusting for inflation, salary is higher today than in
1980.
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Correcting Variables for Inflation:
Indexation
A dollar amount is indexed for inflation
indexed
if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI automatically
determines
the COLA in many multi-year labour contracts
Tax brackets
the adjustments in Canada Pension Plan and Social
Security benefits are adjusted annually.
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Case Study: Mr. Index Goes to Hollywood
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Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
the interest rate not corrected for inflation
the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
corrected for inflation
the rate of growth in the purchasing power of a deposit
or debt
Real interest rate
= (nominal interest rate) (inflation rate)
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Real and Nominal Interest Rates:
EXAMPLE
Deposit $1,000 for one year.
Nominal interest rate is 9%.
During that year, inflation is 3.5%.
Real interest rate
= Nominal interest rate Inflation
= 9.0% 3.5% = 5.5%
The purchasing power of the $1000 deposit
has grown 5.5%.
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Real and Nominal Interest Rates
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CHAPTER SUMMARY
The Consumer Price Index is a measure of the cost of
living. The CPI tracks the cost of the typical consumers
basket of goods & services.
The CPI is used to make Cost of Living Adjustments,
and to correct economic variables for the effects of
inflation.
The real interest rate is corrected for inflation,
and is computed by subtracting the inflation rate from the
nominal interest rate.
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End: Chapter 6
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