Introduction to Macroeconomics Chapter 11 Measuring the Cost of Living Inflation, CPI, and Prices

Use a price index to measure overall prices in an economy Cost of Living Another measure of what is happening in the economy is the cost of living Prices of many goods and services change in different directions – some increase, some decrease, some stay the same When the majority of prices increase – inflation! Use a price index to measure overall prices in an economy

The Consumer Price Index (CPI) Measures the typical consumer’s cost of living CPI is made up of a fixed basket of goods whose prices change year over year The change in prices for the basket of goods indicates inflation 3

How the CPI Is Calculated Fix the “basket.” Determine what goods make it into the basket Quantity of goods remains constant Find the prices. Determine the prices of each good Prices change Compute the basket’s cost. Cost of the basket = number of goods in basket x price of each good 4

How the CPI Is Calculated Choose a base year and compute the index. Cost of basket in current year Cost of basket in base year CPI = X 100 5. Compute the inflation rate. CPI this year – CPI last year CPI last year Inflation rate x 100% = 5

Application 1 Consider an economy where the typical consumer consumes 10 lbs. of beef and 20 lbs. of chicken. These are the two goods in the CPI basket. What is the CPI each year if the base year is 2010? What is the inflation rate in 2011 and 2012? price of beef price of chicken 2010 $4 2011 $5 2012 $9 $6 Part A is not difficult but requires an intermediate step: students must compute the cost of the basket in 2011 to find the CPI in 2011. Part B has two intermediate steps: computing the cost of the basket in 2012, then computing the CPI in 2012.

Application 1 Inflation: 2010 - 2011: (125 – 100)/100 = 25% PxQ Beef PxQ Chicken Cost of the Basket CPI 2010 $40 $80 $120 100 2011 $50 $100 $150 125 2012 $90 $210 175 Inflation: 2010 - 2011: (125 – 100)/100 = 25% 2011 – 2012: (175 – 125)/100 = 40%

What’s in the CPI’s Basket? Each number is the percent of the “typical” household’s total expenditure. Ask students for examples of how the breakdown of their own expenditure differs from that of the typical household shown here. Then, ask students how the typical elderly person’s expenditure might differ from that shown here. (This is relevant because the CPI is used to give Social Security COLAs to the elderly; however, the elderly spend a much larger fraction of their income on medical care, a category in which prices grow much faster than the CPI.) The Web site listed below also gives a very fine disaggregation of each category, which enables students to compare their own spending on individual goods to that of the “typical” household. Source: Bureau of Labor Statistics

Finding Inflation Data Go to http://databank.worldbank.org/data/home.aspx Click on “World Development Indicators” Choose 4-5 countries from the list In series – Choose Inflation In Time – Choose 2000 – 2015 (or recent 15 years) Download the data Download option  Excel Open Excel File Copy data  paste in new sheet (Transpose) Add Year column in Column A Create a line graph What do you observe from your data? What has been happening with prices in these economies?

Prices across time 𝑽𝒂𝒍𝒖𝒆 𝑻𝒐𝒅𝒂𝒚=𝑽𝒂𝒍𝒖𝒆 𝑷𝒂𝒔𝒕 ∗ 𝑪𝑷𝑰 𝑻𝒐𝒅𝒂𝒚 𝑪𝑷𝑰 𝑷𝒂𝒔𝒕 We can adjust prices for inflation to compare value across time:  𝑽𝒂𝒍𝒖𝒆 𝑻𝒐𝒅𝒂𝒚=𝑽𝒂𝒍𝒖𝒆 𝑷𝒂𝒔𝒕 ∗ 𝑪𝑷𝑰 𝑻𝒐𝒅𝒂𝒚 𝑪𝑷𝑰 𝑷𝒂𝒔𝒕 Example:  Cost of bread in 1960: $0.60  CPI 1960: 29.6  CPI 2015: 237.1  Cost of 1960’s bread today: $0.60* (237.1/29.6) = $4.80 

Application Pick a typical consumer good you purchase frequently. Find an estimate of the price of that in 1940, 1960, 1980, 2000.  What is the value of that good in 2015 dollars? Is it more or less expensive today?  What implication does this have on today’s standard of living compared to the standard of living in the past? 

Problems with CPI CPI can overstate inflation because of: Substitution Bias When eggs become more expensive, consumers will buy other breakfast products and buy less eggs. This adjustment in quantity is not always taken into account in the cost of the basket. Introduction of New Goods New goods increase the variety of products available to satisfy a consumer’s needs and wants, making each dollar “more valuable”. Without including new goods, CPI misses out on this effect. Unmeasured Quality Changes Improvements in products again increase the value of each dollar, because you get more for each dollar spent. Without accounting for it, cost of living is overstated.

Costs of Inflation Menu costs Shoe-leather costs Drop in purchasing power General confusion and inconvenience

Key Takeaways The CPI shows the cost of a basket of goods and services that most consumers purchase. Though imperfect, it provides a decent reflection on the cost of living in a country and how it changes With the price index (CPI or GDP deflator) we can calculate inflation and adjust for the value of goods overtime