1. Measuring the Cost of Living
Chapter 11
Measuring the Cost of Living

2. Outline Construction of CPI Calculation of CPI and the Inflation Rate
Problems in measuring CPI
GDP Deflator versus CPI
Correcting economic variables for the effects of inflation
Indexation
Real and Nominal interest rates

3. CPI
The Consumer Price Index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.
CPI measures changes in the cost of living over time.
CPI estimates by how much incomes must rise to maintain a constant standard of living.
CPI reflects the purchasing power of the currency
It reports the movement of prices with an index number.

4. Calculating CPI: Various Steps
Fix the Basket: Identify the basket of goods consumed by a typical consumer
Find the Prices: Find the prices of each of the goods and services in the basket for each point in time
Compute the Basket’s Cost: Calculate the cost of the basket of goods and services at different times
Choose a base year and compute the index: Designate one year as the base year.
CPI= (price of basket in current year/ price of basket in base year)x100

5. Calculating CPI: Various Steps
5. Calculate the Inflation Rate: Use the CPI to calculate the inflation rate.
Inflation rate is the percentage change in the price index from the preceding period.

6. What’s in the CPI’s Basket?5 5

7. CPI Monthly Index: Nov 2003 Canada Same month last year Previous month
Change from previous month
Change from same month last year
1992 = 100 %
All items
120.8
122.4
122.7
0.2
1.6
Food
120.4
121.1
122.3 1
Shelter
115.7
118.2
118.3
0.1
2.2
Household operations and furnishings
114
115.1
114.9
-0.2
0.8
Clothing and footwear
105.2
105
104.2
-0.8 -1
Transportation
139.2
139.7
140.9
0.9
1.2
Health and personal care
116.2
117.7
118
0.3
1.5
Recreation, education and reading
126.7
128.3
127.5
-0.6
0.6
Alcoholic beverages and tobacco products
131.9
137
137.6
0.4
4.3
Special aggregates
All items excluding food
121
122.8
All items excluding energy
119.4
121.6
1.8
Energy
136.2
135.4
-1.2
Source: Statistics Canada, CANSIM, table and Catalogue nos XPB and XIB. 5 5

8. 5 5

9. Problems in Measuring The Cost of Living
The CPI is not a perfect measure of the “cost of living.”
Three reasons/problems:
Substitution Bias: Consumers substitute toward goods that have become relatively less expensive
Introduction of new goods: With greater variety consumers need fewer dollars to maintain any given standard of living
Unmeasured quality change: Quality impacts on the value of the currency 12 12

10. The Consumer Price Index versus the GDP Deflator
The CPI:
includes only consumption goods
includes the cost of imports
is a fixed bundle of goods
The GDP Price Deflator:
includes all final goods and services
excludes imports
uses a current bundle of goods 17 17

11. Correcting Economic Variables for the Effects of Inflation
To convert (inflate) past wages and prices into current terms:
Current Year Dollars =
Past Year Nominal Value X [(Price index in current year) ÷ (Price index in past year)] 21 21

12. Correcting Economic Variables for the Effects of Inflation
To convert (deflate) current wages and prices into past year terms:
Value in Past Year Dollars =
Current Year Value X [(Price index in past year) ÷ (Price index in current year)] 22 22

13. Indexation
Indexation is the automatic correction of a dollar amount for the effects of inflation by law or contract. E.g., COLA
Real interest rate= Nominal interest rate- Inflation rate 17 17

14. Inflation in Canada: CPI inflation