1. Harcourt Brace & Company MEASURING THE COST OF LIVING Chapter 24

2. Harcourt Brace & Company Consumer Price Index n The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. n It is used to monitor changes in the cost of living over time.

3. Harcourt Brace & Company Consumer Price Index n When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

4. Harcourt Brace & Company How the Consumer Price Index Is Calculated n Fix the Basket: Determine goods most important to the typical consumer. ä The Bureau of Labor Statistics (BLS) identifies a market basket of g/s the typical consumer buys. ä The BLS conducts monthly surveys to determine what they buy and how much they pay.

5. Harcourt Brace & Company How the Consumer Price Index Is Calculated n Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

6. Harcourt Brace & Company Calculating the Consumer Price Index and the Inflation Rate n Base Year is 1990 n Basket of goods in 1990 cost $1,200 n The same basket in 1991 costs $1,236 n CPI = ($1,236/$1,200) X 100 = 103 n Prices increased 3 percent between 1990 and 1991

7. Harcourt Brace & Company What’s in the CPI’s Basket?

8. Harcourt Brace & Company Other Price Indexes n The BLS calculates other prices indexes: ä The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

9. Harcourt Brace & Company Problems in Measuring The Cost of Living n The CPI is an accurate measure but it is not a perfect measure of the cost of living.

10. Harcourt Brace & Company Substitution Bias n The basket does not change to reflect consumer reaction to changes in relative prices. ä Consumers substitute toward goods that have become relatively less expensive. ä The index overstates the increase in cost of living.

11. Harcourt Brace & Company Introduction of New Goods n The bundle does not reflect the effects of new products. ä New products result in greater variety, which in turn makes each dollar more valuable. ä Consumers need fewer dollars to maintain any given standard of living.

12. Harcourt Brace & Company Unmeasured Quality Changes n If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.

13. Harcourt Brace & Company Problems with CPI n The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living by 0.5 to 2.0 percentage points per year.

14. Harcourt Brace & Company The Consumer Price Index versus the GDP Deflator n Both the GDP deflator and the consumer price index gauge how quickly prices are rising. n There are important differences between the two.

15. Harcourt Brace & Company The Consumer Price Index versus the GDP Deflator n The CPI...... includes only consumer goods.... includes imports.... is measured using a fixed basket of goods and services.

16. Harcourt Brace & Company The Consumer Price Index versus the GDP Deflator n The GDP Price Deflator...... includes all goods and services produced domestically.... excludes imports.... is measured using currently produced goods and services.

17. Harcourt Brace & Company Correcting Economic Variables for the Effects of Inflation n Price indexes are used to correct for the effects of inflation when comparing dollar figures from different times.

18. Harcourt Brace & Company Correcting Economic Variables for the Effects of Inflation n This is called indexing for inflation.

19. Harcourt Brace & Company Correcting Economic Variables for the Effects of Inflation n Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 1995:

20. Harcourt Brace & Company Correcting Economic Variables for the Effects of Inflation n Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 1995:

21. Harcourt Brace & Company Correcting Economic Variables for the Effects of Inflation n Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 1995:

22. Harcourt Brace & Company Real and Nominal Interest Rates n Interest represents a payment in the future for a transfer of money in the past.

23. Harcourt Brace & Company Real and Nominal Interest Rates Nominal interest rate = Real interest rate + Inflation

24. Harcourt Brace & Company Real and Nominal Interest Rates n You borrowed $1,000 for one year. n Nominal interest rate was 15%. n During the year inflation was 10%. Nominal interest rate = Real interest rate + Inflation 15% = 10% + 5%