1 Chap 11, Mankiw - Measuring cost of living The price indices – consumer, producer Issues related to the measurement of cost of living Adjusting variables for the rate of inflation

2 I.The price indices the consumer price index (CPI) the producer price index (PPI) steps in calculating CPI and measuring cost

3 Calculating the Consumer Price Index and the Inflation Rate: An Example Step 1:Survey Consumers to Determine a Fixed Basket of Goods

4 Calculating the Consumer Price Index and the Inflation Rate: An Example Step 2: Find the Price of Each Good in Each Year

5 Calculating the Consumer Price Index and the Inflation Rate: An Example Step 3: Compute the Cost of the Basket of Goods in Each Year

6 Calculating the Consumer Price Index and the Inflation Rate: An Example Step 4: Choose One Year as the Base Year (2001) and Compute the Consumer Price Index in Each Year

7 Calculating the Consumer Price Index and the Inflation Rate: An Example Step 5: Use the Consumer Price Index to Compute the Inflation Rate from Previous Year

8 Housing Food/Beverages Transportation Medical Care Apparel Recreation Other Education and communication What’s in the CPI’s Basket? 40% 16% 17% 6% 5% 6% 5% 5%

9 II. Issues in the measurement of cost of living A. Problems in constructing the CPI 1.Substitution bias Consumers substitute toward goods and away The basket The index _____________ the increase in cost of living by not considering consumer substitution. ex:

10 2. Introduction of new goods The basket New products result in, which in turn makes each dollar ex: 3. Unmeasured quality change If the quality of a good rises from one year to the next, the value of a dollar, even if the price of the good. By not ex:

11 B. The GDP Deflator versus the Consumer Price Index Both the GDP deflator and the consumer price index measures how quickly prices are rising - two important differences between the two, 1. The GDP deflator reflects the prices of all goods and services and includes The CPI reflects the prices of all goods and services 2. The CPI compares the price of a fixed basket of goods & services The GDP deflator compares the price of currently

Percent per Year CPI Two Measures of Inflation GDP deflator

13 III. Correcting for effects of inflation deflating dollar figures from different times salary in 2006 dollars = salary in 2000 dollars x Suppose US economy has a 3% inflation rate. If the CPI for 2000 is 100, (price level in 2006/price level in 2000) = A person getting $50,000 in 2000 must get today, in order to enjoy the same standard of living indexation of contracts The above formula is very often used to write salary or other financial contracts real and nominal interest rates Real interest rate = nominal interest rate – inflation rate

Interest Rates (percent per year) Nominal interest rate Real interest rate Real and Nominal Interest Rates