Measuring the Cost of Living The Consumer Price Index (CPI) The Producer Price Index (PPI) The GDP Deflator Real vs. Nominal Rates of Interest

The CPI CPI provides a measure of the overall cost of goods and services bought by a typical consumer Attempts to measure changes in cost of living How much income must rise in order to maintain living standards

Calculating the CPI A fixed basket of goods and services is determined by interviewing consumers Prices for the goods and services in the fixed basket are determined for each time period The cost of the fixed basket in different time periods is calculated Price can change, but quantity is constant

Calculating the CPI A base year is chosen in order to calculate the CPI (Current Price GS/Base Price GS) * 100 Index for base year will always be 100 Base is 1999 and cost of g/s in 1995 is 100 Index for 1999 is 100/100 x 100 = 100 Cost of g/s in 2002 is 114 Index for 2002 is 114/100 * 100 = 114

Calculating the CPI CPI is used to calculate the rate of inflation [(New index - Old index)/Old index] * 100 From previous example: [(114 - 100)/100] * 100 = [14/100] * 100 = .14 * 100 = 14 percent rate of inflation over 1999 - 2002 period

Calculating the CPI The BLS (Bureau of Labor Statistics) calculates the CPI for the entire country as well as the CPI for various regions of the county In addition, the BLS calculates indexes for certain components of the CPI (ex. Housing, etc.)

Problems with CPI Purpose of the CPI is to measure changes in the cost of living Problems with CPI arise because it is based on a fixed basket of goods and services

Problems with CPI Substitution bias arises with CPI When goods and services become more expensive, consumers substitute away from more expensive goods & services to cheaper goods and services Index is fixed, so does not take this substitution into account; index overstates the cost of living

Problems with CPI CPI does not take into account that new goods are introduced on the market Basket is fixed, so it does not reflect the greater variety available to consumers Greater variety makes each dollar more valuable so fewer dollars are needed to maintain a standard of living The fixed basket does not reflect this change in the dollar’s purchasing power

Problems with CPI Quality changes are difficult to measure and are not totally reflected in the CPI If quality increases, the dollar’s value will increase, even if price is constant The BLS tries to account for quality changes, but its account is imperfect

Problems with CPI We are concerned about the above problems because many programs are tied to the CPI through indexation About of 1/3 of government programs are indexed to inflation as well as many private contracts Indexation refers to the automatic correction of dollar amounts for inflation

PPI vs CPI PPI measures the cost of goods and services bought by a typical firm PPI thought to be a useful predictor of changes in the CPI

GDP Deflator vs CPI The GDP deflator reflects the prices of all domestically produced goods and services while the CPI reflects the prices of goods bought by the typical consumer The CPI and the GDP deflator tend to move together, but can diverge

GDP Deflator vs CPI The GDP deflator would reflect the prices of military goods; the CPI would not The GDP deflator reflects only domestically produced goods; the CPI can also reflect imports bought by consumers The GDP deflator is not based on a fixed basket of goods and services

Real & Nominal Interest Rates Nominal interest rate is the interest rate usually reported; it is not corrected for inflation Real interest rate is the interest rate corrected for inflation Real rate = Nominal rate - Inflation rate

Real & Nominal Interest Rates Nominal interest rate: how fast dollars in the bank grow over time Real interest rate: how fast the purchasing power of dollars in the bank grows over time

Real & Nominal Interest Rates Rate of inflation = 3% Real interest rate = 6.7% - 3% = 3.7% Dollars in the bank are growing at 6.7%, but the purchasing power of those dollars is only growing at 3.7%