Measuring the Cost of Living Chapter 11 Copyright © 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring the Cost of Living u Inflation refers to a situation in which the economy’s overall price level is rising. u The inflation rate is the percentage change in the price level from the previous period.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Consumer Price Index u The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. u The Bureau of Labor Statistics reports the CPI each month. u It is used to monitor changes in the cost of living over time.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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%

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Consumer Price Index Is Calculated u Fix the Basket: Determine what prices are most important to the typical consumer. u Find the Prices: Find the prices of each of the goods and services in the basket for each point in time. u Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. How the Consumer Price Index Is Calculated u Choose a Base Year and Compute the Index: u Designate one year as the base year, making it the benchmark against which other years are compared. u Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100. Current prices x 100 = CPI Base prices

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Inflation Rate u Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Problems in Measuring the Cost of Living u The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. u The issue is important because many government programs use the CPI toadjust for changes in the overall level of prices. u The CPI overstates inflation by about 1 percentage point per year.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Indexation When some dollar amount is automatically corrected for inflation by law or contract the amount is said to be indexed for inflation. COLA’s or cost of living adjustments are a form of indexation. Social Security payments are indexed.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. GDP Deflator The GDP deflator is calculated as follows:

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The GDP Deflator versus the Consumer Price Index u The GDP deflator reflects the prices of all goods and services produced domestically, whereas... u …the consumer price index reflects the prices of all goods and services bought by consumers.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The GDP Deflator versus the Consumer Price Index u 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 BLS change the basket)... u …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.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Percent per Year CPI Two Measures of Inflation GDP deflator

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Other Price Indexes u The BLS calculates other prices indexes: u The index for different regions within the country. u The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real and Nominal Interest Rates Interest represents a payment in the future for a transfer of money in the past.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real and Nominal Interest Rates u The nominal interest rate is the interest rate not corrected for inflation. u It is the interest rate that a bank pays. u The real interest rate is the nominal interest rate that is corrected for inflation. Real interest rate = (Nominal interest rate – Inflation rate)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Real and Nominal Interest Rates u You borrowed $1,000 for one year. u Nominal interest rate was 15%. u During the year inflation was 10%. Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5%

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc Interest Rates (percent per year) Nominal interest rate Real interest rate Real and Nominal Interest Rates

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Causes of inflation u Demand Pull Theory – demand for goods & services exceeds existing supply. One reason for this is too much money in circulation. u Cost Push Theory- producers raise prices in order to meet increased costs. This is also known as supply shocks (supply curve shifts left).

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Quantity of money or Demand-pull Cost-push or Supply Shock PRICELEVELPRICELEVEL PRICELEVELPRICELEVEL REAL GDP AS AD 1 AD2 AS 2 AS1 AD

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Who’s Hurt? Who’s Helped? You’re hurt if you are a u Creditor – the money you loan out is worth less when its paid back u Saver – inflation rates are normally higher than interest rates u Fixed income receiver- a constant income will buy less. You’re helped if you are a u Borrower- the money you are repaying is worth less u Flexible income earner- äif your income is tied to profits you will earn more äIf your income is adjusted for inflation you will earn more (COLA) u Payer of fixed amounts