The CPI and the Cost of Living

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The CPI and the Cost of Living

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Title: The CPI and the Cost of Living


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22
The CPI and the Cost of Living
CHAPTER
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C H A P T E R C H E C K L I S T
  • When you have completed your study of this
    chapter, you will be able to
  • 1 Explain what the Consumer Price Index (CPI) is
    and how it is calculated.
  • 2 Explain the limitations of the CPI and
    describe other measures of the price level.
  • 3 Adjust money values for inflation and
    calculate real wage rates and real interest rates.

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22.1 THE CONSUMER PRICE INDEX
  • 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.
  • The BLS calculates the CPI every month.
  • We can use these numbers to compare what a fixed
    basket of goods costs this month with what it
    cost in some previous month.

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22.1 THE CONSUMER PRICE INDEX
  • Reading the CPI Numbers
  • The CPI is defined to equal 100 for a period
    called the reference base period.
  • Reference base period is a period for which the
    CPI is defined to equal 100. Currently, the
    reference base period is 1982?1984.

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22.1 THE CONSUMER PRICE INDEX
  • In August 2007, the CPI was 207.9.
  • The average of the prices paid by urban consumers
    for a fixed market basket of consumer goods and
    services was 107.9 percent higher in August 2007
    than it was on the average during 1982?1984.
  • In July 2007, the CPI was 208.3.
  • The average of the prices paid by urban consumers
    for a fixed market basket of consumer goods and
    services decreased by 0.4 of a percentage point
    in August 2007.

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22.1 THE CONSUMER PRICE INDEX
  • Constructing the CPI
  • Three stages
  • Selecting the CPI basket
  • Conducting the monthly price survey
  • Calculating the CPI

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22.1 THE CONSUMER PRICE INDEX
  • The CPI Basket
  • Make the relative importance of the items in the
    CPI basket the same as in the budget of an
    average urban household.
  • The CPI is calculated each month, but the CPI
    basket is not updated each month.
  • The current CPI basket in 2007 is based on
    information obtained from the Consumer
    Expenditure Survey conducted during 2005.

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22.1 THE CONSUMER PRICE INDEX
  • Figure 22.1 shows the CPI basket.

This shopping cart is filled with the items that
an average household buys.
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22.1 THE CONSUMER PRICE INDEX
  • The Monthly Price Survey
  • Each month, BLS employees check the prices of the
    80,000 goods and services in the CPI basket in 30
    metropolitan areas.
  • Because the CPI measures price changes, it is
    important that the prices recorded refer to
    exactly the same items.

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22.1 THE CONSUMER PRICE INDEX
  • Calculating the CPI
  • The CPI calculation has three steps
  • Find the cost of the CPI basket at base period
    prices.
  • Find the cost of the CPI basket at current period
    prices.
  • Calculate the CPI for the base period and the
    current period.
  • Table 22.1 on the next slide shows a simplified
    CPI calculation in which we assume a base period
    of 2005.

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22.1 THE CONSUMER PRICE INDEX
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22.1 THE CONSUMER PRICE INDEX
  • CPI

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22.1 THE CONSUMER PRICE INDEX
  • Measuring Inflation
  • Inflation rate is the percentage change in the
    price level from one year to the next.

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22.1 THE CONSUMER PRICE INDEX
  • Figure 22.2 shows the CPI in part (a) and the
    inflation rate in part (b).

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22.1 THE CONSUMER PRICE INDEX
  • In part (a), the price level has increased every
    year. The rate of increase was rapid during the
    early 1980s and slower during the 1990s.

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22.1 THE CONSUMER PRICE INDEX
  • In part (b), the inflation rate was high during
    the early 1980s, but low during the 1990s.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Cost of living index is a measure of 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
    because
  • It does not measure all the components of the
    cost of living
  • Some components are not measured exactly
  • So the CPI is possibly a biased measure.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • 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

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • New Goods Bias
  • New goods do a better job than the old goods that
    they replace, but cost more.
  • The arrival of new goods puts an upward bias into
    the CPI and its measure of the inflation rate.
  • Quality Change Bias
  • Better cars and televisions cost more than the
    versions they replace.
  • A price rise that is a payment for improved
    quality is not inflation but might get measured
    as inflation.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Commodity Substitution Bias
  • If the price of beef rises faster than the price
    of chicken, people buy more chicken and less
    beef.
  • The CPI basket doesnt change to allow for the
    effects of substitution between goods.
  • Outlet Substitution Bias
  • If prices rise more rapidly, people use discount
    stores more frequently.
  • The CPI basket doesnt change to allow for the
    effects of outlet substitution.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • The Magnitude of the Bias
  • The Boskin Commission estimated the bias to be
    1.1 percentage points per year.
  • If the measured inflation rate is 3.1 percent a
    year, most likely the actual inflation rate is
    2.0 percent a year.
  • To reduce the bias, the BLS has decided to
    increase the frequency of its Consumer
    Expenditure Survey and revise the CPI basket
    every two years.
  • When the BLS revises the CPI basket, the
    reference base period does not change.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Two Consequences of the CPI Bias
  • Two main consequences of the bias in the CPI are
  • Distortion of private contracts
  • Increases in government outlays and decreases in
    taxes
  • Distortion of Private Contracts
  • Many wage contracts are linked to the CPI.
  • If the CPI is biased, these contracts might
    deliver an outcome different from that intended
    by the parties.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Suppose that the UAW and GM sign a 3 year wage
    deal In the first year, the wage will be 30 an
    hour and will rise by the inflation rate in the
    next two years.
  • If the inflation rate is 5 percent a year, the
    wage rises to 31.50 an hour in the second year
    and 33.08 an hour in the third year.
  • But if the actual inflation rate is 2 percent a
    year, the intended wages in the second and third
    years are 30.90 an hour and 31.83 an hour.
  • The workers gain is GMs loss. With thousands of
    workers, GMs loss would be millions of dollars
    over the 3 years.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Increases in Government Outlays and Decreases in
    Taxes
  • Close to a third of federal government outlays
    are linked directly to the CPI.
  • The CPI is used to adjust
  • 48 million Social Security benefit payments
  • 22 million food stamp payments
  • 4 million pensions for retired military
    personnel, federal civil servants, and their
    surviving spouses
  • the budget for 27 million school lunches

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • The CPI is used to adjust the income levels at
    which higher tax rates apply.
  • Because tax rates on large incomes are higher
    than those on small incomes as incomes rise, the
    burden of taxes would rise relentlessly if these
    adjustments were not made.
  • To the extent that the CPI is biased upward, the
    tax adjustments over-compensate for rising prices
    and decrease the amount paid in taxes.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Alternative Measures of the Price Level
  • Several alternative measures of the price level
    are available.
  • Here we look at
  • The GDP deflator
  • The personal consumption expenditures
    deflator (PCE deflator)

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • GDP Deflator
  • The GDP deflator is an average of current prices
    of all the goods and services included in GDP
    expressed as a percentage of base-year prices.
  • GDP deflator (Nominal GDP ? Real GDP) ? 100.
  • The GDP deflator is a measure of the price level
    and the percentage change in the GDP deflator is
    a measure of the inflation rate.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Two key differences between the GDP deflator and
    the CPI result in different estimates of the
    price level and inflation rate.
  • The GDP deflator uses the prices of all the goods
    and services in GDP whereas the CPI uses prices
    of consumption goods and services only.
  • 2. The GDP deflator weights each item using
    information about current as well as past
    quantities. In contrast, the CPI weights each
    item using information from a past consumer
    expenditure survey.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • Because the GDP deflator uses information on
    current year quantities, it includes new goods
    and quality improvements and even allows for
    substitution effects of both commodities and
    retail outlets.
  • So in principle, the GDP deflator is not subject
    to the biases of the CPI.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • In practice, the GDP deflator suffers from some
    of the CPIs problems because the Commerce
    Department does not directly measure the physical
    quantities of all the goods and services that are
    produced.
  • Instead, to estimate quantities, the Commerce
    Department divides expenditures by price indexes.
  • And one of these price indexes is the CPI.
  • So the biased CPI injects a bias into the GDP
    deflator.

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22.2 THE CPI AND OTHER PRICE LEVEL MEASURES
  • 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.
  • The PCE deflator has the same advantages as GDP
    deflatorit uses current information on
    quantities and to some degree overcomes the
    sources of bias in the CPI.
  • The PCE deflator, like the CPI, is a possible
    measure of the cost of living.

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22.2 THE CPI AND OTHER
  • Figure 22.3 shows the three measures of inflation
    in part (a) and the corresponding measures of the
    price level in part (b).
  • The three measures of the inflation rate
    fluctuate together, but the CPI measure rises
    more rapidly than the GDP deflator measure or the
    PCE deflator measure.

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22.2 THE CPI AND OTHER
  • In part (b), the CPI measure of the price level
    is the highest and the PCE deflator lies between
    the CPI and the GDP deflator.
  • The CPI measure overstates the inflation rate.

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22.3 NOMINAL AND REAL VALUES
  • Dollars and Cents at Different Dates
  • To compare dollar amounts at different dates, we
    need to know the CPI at those dates.
  • Convert the price of a 2-cent stamp in 1907 into
    its 2007 equivalent

Price of stamp in 2007 dollars
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22.3 NOMINAL AND REAL VALUES
  • Nominal and Real Values in Macroeconomics
  • Macroeconomics makes a big issue of the
    distinction between nominal values and real
    values
  • Nominal GDP and real GDP
  • Nominal wage rate and real wage rate
  • Nominal interest rate and real interest rate
  • We studied the distinction between and
    calculation of nominal and real GDP in Chapter
    21. Here, well look at the other two.

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22.3 NOMINAL AND REAL VALUES
  • Nominal and Real Wage Rates
  • Nominal wage rate Iis the average hourly wage
    rate measured in current dollars.
  • Real wage rate is the average hourly wage rate
    measured in the dollars of a given reference base
    year.

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22.3 NOMINAL AND REAL VALUES
To calculate the real wage rate, we divide the
nominal wage rate by the CPI and multiply by 100.
That is,
The 8.23 amount is in 1982?1984 dollars.
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22.3 NOMINAL AND REAL VALUES
  • Figure 22.4 shows nominal and real wage rates
    19822006.

The nominal wage rate has increased every year
since 1982.
The real wage rate decreased slightly from 1982
through the mid-1990s, after which increased
slightly.
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22.3 NOMINAL AND REAL VALUES
  • Nominal and Real Interest Rates
  • Nominal interest rate is the percentage return on
    a loan expressed in dollars.
  • Real interest rate is the percentage return on a
    loan, calculated by purchasing powerthe nominal
    interest rate adjusted for the effects of
    inflation.
  • Real interest rate Nominal interest rate
    Inflation rate.

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22.3 NOMINAL AND REAL VALUES
  • Figure 22.5 shows real and nominal interest
    rates 19672007.

During the 1970s, the real interest rate became
negative.
The nominal interest rate increased during the
high-inflation 1980s.
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