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

2. 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

3. 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

4. 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

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

6. 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.)

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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%