1、Measuring the Cost of Living,Economics,P R I N C I P L E S O F,N. Gregory Mankiw,Premium PowerPoint Slides by Ron Cronovich,24,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

2、? 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?,1,MEASURING THE COST OF LIVING,2,The Consumer Price Index (CPI),measure

3、s the typical consumers cost of living the basis of cost of living adjustments (COLAs) in many contracts and in Social Security,0,MEASURING THE COST OF LIVING,3,How the CPI Is Calculated,Fix the “basket.”The Bureau of Labor Statistics (BLS) surveys consumers to determine whats in the typical consume

4、rs “shopping basket.” Find the prices.The BLS collects data on the prices of all the goods in the basket. Compute the baskets cost.Use the prices to compute the total cost of the basket.,0,MEASURING THE COST OF LIVING,4,How the CPI Is Calculated,Choose a base year and compute the index.The CPI in an

5、y year equals,Compute the inflation rate.The percentage change in the CPI from the preceding period.,0,MEASURING THE COST OF LIVING,5,EXAMPLE,basket: 4 pizzas, 10 lattes,$12 x 4 + $3 x 10 = $78,$11 x 4 + $2.5 x 10 = $69,$10 x 4 + $2 x 10 = $60,cost of basket,Compute CPI in each year 2007: 100 x ($60

6、/$60) = 100 2008: 100 x ($69/$60) = 115 2009: 100 x ($78/$60) = 130,Inflation rate:,0,using 2007 base year:,A C T I V E L E A R N I N G 1 Calculate the CPI,6,CPI basket: 10 lbs beef, 20 lbs chicken The CPI basket cost $120 in 2004, the base year.,A.Compute the CPI in 2005. B.What was the CPI inflati

7、on rate from 2005-2006?,0,A C T I V E L E A R N I N G 1 Answers,7,0,0,A.Compute the CPI in 2005:,Cost of CPI basket in 2005= ($5 x 10) + ($5 x 20) = $150 CPI in 2005 = 100 x ($150/$120) = 125,CPI basket: 10 lbs beef, 20 lbs chicken The CPI basket cost $120 in 2004, the base year.,A C T I V E L E A R

8、 N I N G 1 Answers,8,0,0,CPI basket: 10 lbs beef, 20 lbs chicken The CPI basket cost $120 in 2004, the base year.,B.What was the inflation rate from 2005-2006?,Cost of CPI basket in 2006= ($9 x 10) + ($6 x 20) = $210 CPI in 2006 = 100 x ($210/$120) = 175 CPI inflation rate = (175 125)/125 = 40%,MEAS

9、URING THE COST OF LIVING,9,Whats in the CPIs Basket?,0,CPI basket: 10# beef, 20# chicken 2004-5: Households bought CPI basket. 2006: Households bought 5 lbs beef, 25 lbs chicken.,A C T I V E L E A R N I N G 2 Substitution bias,10,A.Compute cost of the 2006 household basket. B.Compute % increase in c

10、ost of household basket over 2005-6, compare to CPI inflation rate.,0,A C T I V E L E A R N I N G 2 Answers,11,A.Compute cost of the 2006 household basket. ($9 x 5) + ($6 x 25) = $195,CPI basket: 10# beef, 20# chicken Household basket in 2006: 5# beef, 25# chicken,A C T I V E L E A R N I N G 2 Answe

11、rs,12,B.Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate. Rate of increase: ($195 $150)/$150 = 30% CPI inflation rate from previous problem = 40%,CPI basket: 10# beef, 20# chicken Household basket in 2006: 5# beef, 25# chicken,MEASURING THE COST OF LIVING,13,

12、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.,0,MEASURING T

13、HE COST OF LIVING,14,Problems with the CPI: Introduction of New Goods,The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Th

14、us, the CPI overstates increases in the cost of living.,0,MEASURING THE COST OF LIVING,15,Problems with the CPI: Unmeasured Quality Change,Improvements in the quality of goods in the basket increase the value of each dollar. The BLS tries to account for quality changes but probably misses some, as q

15、uality is hard to measure. Thus, the CPI overstates increases in the cost of living.,0,MEASURING THE COST OF LIVING,16,Problems with the CPI,Each of these problems causes the CPI to overstate cost of living increases. The BLS has made technical adjustments, but the CPI probably still overstates infl

16、ation by about 0.5 percent per year. This is important because Social Security payments and many contracts have COLAs tied to the CPI.,0,MEASURING THE COST OF LIVING,17,Two Measures of Inflation, 1950-2007,0,MEASURING THE COST OF LIVING,18,Imported consumer goods: included in CPI excluded from GDP d

17、eflator,The basket: CPI uses fixed basket GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts.,Capital goods: excluded from CPI included in GDP deflator (if produced domestically),Contrasting the CPI and GDP Deflator,0,In

18、 each scenario, determine the effects on the CPI and the GDP deflator. A.Starbucks raises the price of Frappuccinos. B.Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C.Armani raises the price of the Italian jeans it sells in the U.S.,A C T I V E L E

19、A R N I N G 3 CPI vs. GDP deflator,19,A.Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B.Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C.Armani raises the price of the Italia

20、n jeans it sells in the U.S. The CPI rises, the GDP deflator does not.,A C T I V E L E A R N I N G 3 Answers,20,MEASURING THE COST OF LIVING,21,Correcting Variables for Inflation:Comparing Dollar Figures from Different Times,Inflation makes it harder to compare dollar amounts from different times. E

21、xample: the minimum wage $1.15 in Dec 1964 $5.85 in Dec 2007 Did min wage have more purchasing power in Dec 1964 or Dec 2007? To compare, use CPI to convert 1964 figure into “todays dollars”,0,MEASURING THE COST OF LIVING,22,In our example, year T = 12/1964, “today” = 12/2007 Min wage = $1.15 in yea

22、r T CPI = 31.3 in year T, CPI = 211.7 today,Correcting Variables for Inflation:Comparing Dollar Figures from Different Times,0,0,Amount in todays dollars,Amount in year T dollars,=,x,$7.78,$1.15,=,x,The minimum wage in 1964 was $7.78 in todays (2007) dollars.,MEASURING THE COST OF LIVING,23,Correcti

23、ng Variables for Inflation:Comparing Dollar Figures from Different Times,Researchers, business analysts and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures. They can then see how a variable has changed over time a

24、fter correcting for inflation. Example: the minimum wage, from Jan 1950 to Dec 2007,0,The U.S. Minimum Wage in Current Dollarsand Todays Dollars, 1950-2007,$ per hour,$0,$1,$2,$3,$4,$5,$6,$7,$8,$9,1950,1955,1960,1965,1970,1975,1980,1985,1990,1995,2000,2005,Annual tuition and fees, average of all pub

25、lic four-year colleges & universities in the U.S. 1986-87: $1,414 (1986 CPI = 109.6) 2006-07: $5,834 (2006 CPI = 203.8) After adjusting for inflation, did students pay more for college in 1986 or in 2006? Convert the 1986 figure to 2006 dollars and compare.,A C T I V E L E A R N I N G 4 Converting t

26、o “todays dollars”,25,A C T I V E L E A R N I N G 4 Answers,26,Solution Convert 1986 figure into “todays dollars” $1,414 x (203.8/109.6) = $2,629 Even after correcting for inflation, tuition and fees were much lower in 1986 than in 2006!,Annual tuition and fees, average of all public four-year colle

27、ges & universities in the U.S. 1986-87: $1,414 (1986 CPI = 109.6) 2006-07: $5,834 (2006 CPI = 203.8),MEASURING THE COST OF LIVING,27,Correcting Variables for Inflation:Indexation,For example, the increase in the CPI automatically determines the COLA in many multi-year labor contracts the adjustments

28、 in Social Security payments and federal income tax brackets,A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.,0,MEASURING THE COST OF LIVING,28,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 ra