Macroeconomics Test #203/24/2015°°Chapter 11 – Measuring the Cost of Living°The consumer price index (CPI)is a measure of the overall cost of the goods and services bought by a typical consumer.Calculation:°1)Fix the basket. Determine which prices are most important to the typicalconsumer. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgersand, therefore, should be given greater weight in measuring the cost of living. The BLS sets these weights by surveying consumers to find the basket of goods and services bought by the typical consumer. In the example in the table, the typical consumer buys a basket of hot dogs and hamburgers.2)Find the prices.Find the prices of each of the goods and services in the basket at each point in time. The table shows the prices of hot dogs and hamburgers for three different years.

3)Compute the basket’s cost.Use the data on prices to calculate the costof the basket of goods and services at different times. The table shows this calculation for each of the three years. Notice that only the prices in this calculation change. By keeping the basket of goods the same ( hot dogs and hamburgers), we are isolating the effects of price changes from the effects of any quantity changes that might be occurring at the same time.4)Choose a base year and compute the index.Designate one year as the base year, the benchmark against which other years are compared. (The choice of base year is arbitrary, as the index is used to measure changesin the cost of living.) Once the base year is chosen, the index is calculated as follows: °°5)Compute the inflation rate.Use the consumer price index to calculate the inflation rate, which is the percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows:Producer price index(PPI), which measures the cost of a basket of goods and services bought by firms rather than consumers.°The consumer price index, however, is nota perfect measure of thecost of living. Three problems with the index are widely acknowledged but difficult to solve.1.Substitution bias– When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others.If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitutionand, therefore, overstates the increase in the cost of living from one year to the next.2.Introduction of new goods–

When a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being.