Measuring the Cost of Living 24 Measuring the Cost of Living

Measuring the Cost of Living Inflation refers to a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

Measuring inflation Inflation is a fact of life: very few exceptions aside, all economies in the world have some experience with inflation A small number of economies, among them Turkey, know very high and persistent inflation In this chapter, we take our first shot at inflation Explaining inflation will have to wait a little Now we shall look into measuring inflation We already encountered a measure of inflation with the GDP deflator Inflation is usually measured by the use of price indexes such as the Consumer Price Index and the Producer or Wholesale Price Index

THE CONSUMER PRICE INDEX The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. It is used to monitor changes in the cost of living over time.

THE CONSUMER PRICE INDEX When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

Consumer price index – CPI In Turkey the consumer inflation is measured by Tüketici Fiyatları Endeksi – TÜFE – calculated by TÜİK Other institutions, such as the ITO – Istanbul Chamber of Commerce – also calculates indexes to measure changes in cost of living

How the Consumer Price Index Is Calculated Fix the Basket: Determine what prices are most important to the typical consumer. TUIK identifies a market basket of goods and services the typical consumer buys. The TUIK conducts monthly consumer surveys to set the weights for the prices of those goods and services.

Calculating price indexes The consumption basket is determined by TÜİK through a “Consumer Survey” of the population The previous index is based on a consumer survey undertaken in 2003 All the goods and services consumed by the typical household as observed in the survey during 2003 are in the basket

How the Consumer Price Index Is Calculated Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

How the Consumer Price Index Is Calculated Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

The cost of the basket TÜİK collects the prices from different retail outlets about the prices of the goods and services in the basket three times every month Thus obtains an average price of the month for each item Then multiplies each average price with its weight in the basket and adds them up In this way the total cost of filling up the basket in that month is calculated By comparing the cost of the basket this month with the previous month, or the same month a year ago, or that of the base period allows the calculation of inflation

How the Consumer Price Index Is Calculated Choose a Base Year and Compute the Index: 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.

How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

How the Consumer Price Index Is Calculated The Inflation Rate The inflation rate is calculated as follows:

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example Copyright©2004 South-Western

How the Consumer Price Index Is Calculated Calculating the Consumer Price Index and the Inflation Rate: Another Example Base Year is 2002. Basket of goods in 2002 costs $1,200. The same basket in 2004 costs $1,236. CPI = ($1,236/$1,200)  100 = 103. Prices increased 3 percent between 2002 and 2004.

Same inflation, different figures In the short run, the key indicator of inflation is the monthly figure TÜİK publishes on the 3rd day of each month the inflation for the previous month Annual inflation compares the change in prices in 12 months Year-end inflation is annual inflation for the calender year (January to December) Average annual inflation is calculated by taking the average of the annual inflation figures of the last 12 months Monthly inflation can be very volatile while average inflation is more stable

Composition of the CPI basket

Details of CPI index TÜİK publishes other details of the CPI index Subdivisions of major categories: for exemple “Food and Beverages” is divided into three: Food, Beverages, Cigarettes and Tobacco Regional indexes: separate indexes for many cities : Istanbul, Ankara, İzmir, etc. Different income groups: wage earners, rural households, etc. Developed economies also publish detailed local CPI figures such as “white collar employees in county X” Or “CPI excluding food”, “CPI excluding energy”, “CPI excluding rent” etc.

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.

Problems in Measuring the Cost of Living Substitution bias Introduction of new goods Unmeasured quality changes

Problems in Measuring the Cost of Living Substitution Bias The basket does not change to reflect consumer reaction to changes in relative prices. Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution.

Problems in Measuring the Cost of Living Introduction of New Goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living.

Problems in Measuring the Cost of Living Unmeasured Quality Changes If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. The TÜIK tries to adjust the price for constant quality, but such differences are hard to measure.

Problems in Measuring the Cost of Living The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. The CPI overstates inflation by about 1 percentage point per year.

The GDP Deflator versus the Consumer Price Index The GDP deflator is calculated as follows:

The GDP Deflator versus the Consumer Price Index The TÜIK calculates other prices indexes: The index for different regions within the country. The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

Wholesale Price Index All economies calculate a second inflation index trying to measure the input costs of businesses called “Producer Prices Index” In Turkey it was called the Wholesale Price Index – WPI (Toptan Eşya Fiyatları Endeksi – TEFE) TÜİK computes a basket of goods used as inputs by the firms in the economy and uses the same base year as the CPI (1994) WPI distinguishes between prices of private sector firms and public sector firms It has four major categories: agriculture (22.2 %), Mining (2.5 %), Manufacturing (71.1 %) and Energy, Gas & Water (4.2 %)

Comparing WPI and CPI CPI includes only final goods bought by consumers; WPI has only intermediate goods Bread, cheese, shirts, socks, skirts, ties are in CPI Wheat, flour, milk, yarn, cloth, etc. are in WPI Newspapers, cigarettes are in CPI, print paper and tobacco are in WPI 50 % of CPI is services and residential rent Eating at a restaurant, going to a movie, visiting a doctor, taking a bus are only in CPI, there are no services in WPI Renting a house is in CPI, but renting an office is not in WPI

Turkey: monthly inflation

Turkey: annual inflation

Turkey: average and annual CPI

Turkey: average and annual WPI

A.S.Akat EC 102 – Chapter 23

CPI details: February 2002

WPI details: February 2002

The GDP Deflator versus the Consumer Price Index Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two important differences between the indexes that can cause them to diverge.

The GDP Deflator versus the Consumer Price Index The GDP deflator reflects the prices of all goods and services produced domestically, whereas... …the consumer price index reflects the prices of all goods and services bought by consumers.

The GDP Deflator versus the Consumer Price Index The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the TÜİK change the basket)... …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

Figure 2 Two Measures of Inflation Percent per Year 15 CPI 10 GDP deflator 5 1965 1970 1975 1980 1985 1990 1995 2000 Copyright©2004 South-Western

CPI and the GDP deflator Economists and policymakers use both the CPI and the GDP deflator to analyse inflation There are important differences between the two Consumer Price Index includes only consumer goods, includes imports is measured using a fixed basket Gross Domestic Product deflator includes all goods and services domestically produced excludes imports, is measured using currently produced goods and services

Turkey: CPI, WPI and GDP deflator

Correcting for inflation You often hear parents saying something like “we bought this flat for 150.000 TL in 1970” and wonder about how much it was worth today Even at low leves of inflation such as 2-3 % per year, over long periods of time the purchasing power of money changes substantially and needs to be corrected for comparaisons Price indexes are used to make this correction by inflating the original price to current prices Price Index2002 Price Index1970 Price2002 = Price1970 x

Indexation Price indexes are widely used in the economy to correct for the effects of inflation If a payment is automatically corrected for inflation by contract or by law, the payment in question is said to be indexed to inflation The government indexed pensions of Social Security (SSK emeklileri) to CPI: it means pensioners automatically get an increase equal to the CPI change of previous month The tax system is also indirectly indexed to annual inflation with changes in tariffs High inflation countries have developed sophistic-ated indexation systems but not in Turkey

Real and nominal interest It is very important to correct interest rates for inflation Nominal interest rate is the actual interest rate that we see in the market place Real interest rate is corrected for inflation Assume nominal interest rate is 70 % p.a. and annual CPI inflation is 50 % For 1 million TL, after one year you get 1.7 million TL with interest but your 1 million TL has in the meanwhile became 1.5 million TL with inflation Your real interest is only 200 million TL, the rest of the interest you received (500 million TL) goes to offset your loss from inflation

Calculating real interest rate How do you calculate the real interest rate? For low inflation (below 10 % p.a.) a simple rule is: Real interest rate = nominal interest rate –inflation For example, if inflation is 3 % and the nominal interest rate is 6 %, the real interest rate is 3 %

At higher inflation this rule is not applicable. A.S.Akat EC 102 – Chapter 23 At higher inflation this rule is not applicable. Let us call r = real interest rate, i = nominal interest rate and  = inflation rate, all in percentages The full formula becomes: r = [ (1 + i / 1 + ) – 1 ] x 100 For i= 70 % and  = 50 % we get r = 13.3 % r = (1.7 / 1.5) – 1 = (1.13 – 1) x 100 = 13 %

US: nominal & real interest Interest Rates (percent per year) 15 Nominal interest rate 10 5 Real interest rate -5 1965 1970 1975 1980 1985 1990 1995 3

Turkey: nominal & real interest

Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past.

Real and Nominal Interest Rates The nominal interest rate is the interest rate usually reported and not corrected for inflation. It is the interest rate that a bank pays. The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

Real and Nominal Interest Rates You borrowed $1,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

Figure 3 Real and Nominal Interest Rates (percent per year) 15 10 Nominal interest rate 5 Real interest rate –5 1965 1970 1975 1980 1985 1990 1995 2000 Copyright©2004 South-Western

Summary The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate.

Summary The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.

Summary The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Summary Dollar figures from different points in time do not represent a valid comparison of purchasing power. Various laws and private contracts use price indexes to correct for the effects of inflation. The real interest rate equals the nominal interest rate minus the rate of inflation.