ECO2013

MACROECONOMICS
Chapter 25
Measuring the Cost of Living

Prof. Vũ Hoàng Quân

Keiser University Vietnam
CHAPTER
OBJECTIVES
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?

• What are the problems with the CPI? How serious are
they?

• How does the CPI differ from the GDP deflator?

• How can we use the CPI to compare dollar amounts from

different years? Why would we want to do this, anyway?

• How can we correct interest rates for inflation?

2
THE CONSUMER PRICE INDEX (CPI)
• A measure of the overall cost of the goods and services bought
by a typical consumer
• Monitors changes in the cost of living over time

• Computed and reported every month by the Bureau of Labor

Statistics

3
HOW THE CPI IS CALCULATED

1. Fix the “basket.”

The Bureau of Labor Statistics (BLS) surveys consumers
to determine what’s in the typical consumer’s “shopping
basket.”

2. Find the prices.

The BLS collects data on the prices of all the goods in the
basket.
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3. Compute the basket’s cost.
HOW THE CPI IS CALCULATED
4. Choose a base year and compute the
index.
The CPI in any year equals
cost of basket in current
100 x year in base
cost of basket
year
5. Compute the inflation rate.
The percentage change in the CPI from the preceding
period.
Inflatio CPI this year – CPI last
= x 100%
n year
CPI last year
rate
 EXAMPLE
Price
Price of
Year of Cost of basket
latte
pizza $10 x 4 + $2 x 10 =
2021 $10 $2.00
$60
$11 x 4 + $2.5 x 10 =
2022 $11 $2.50
$69
$12 x 4 + $3 x 10 =
2023 $12 $3.00
$78
Compute CPI in each year
(base year: 2021)
Inflation rate:

2021: 100 x ($60/$60) = 100 115 – 100

15% = x 100%
100
2022: 100 x ($69/$60) = 115
130 – 115
2023: 100 x ($78/$60) = 130 13% = x 100%
115
ACTIVE LEARNING 1
Calculate the CPI
CPI basket:
Price Of Price Of
{10 lbs beef, 20 lbs Year
Beef Chicken
chicken}
2015 $4 $4
The CPI basket cost $120
in 2015, the base year. 2016 $5 $5

2017 $9 $6

A. Compute the CPI in 2016.

B. What was the CPI inflation rate from 2016-

2017?
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ACTIVE LEARNING 1
Answers
CPI basket:
Price Of Price Of
{10 lbs beef, 20 lbs Year
Beef Chicken
chicken}
2015 $4 $4
The CPI basket cost $120 in
2016 $5 $5
2015, the base year.
2017 $9 $6
A. Compute the CPI in 2016:
Cost of CPI basket in 2016
= ($5 x 10) + ($5 x 20) = $150
CPI in 2016 = 100 x ($150/$120) = 125
8
ACTIVE LEARNING 1
Answers
CPI basket: Price Of Price Of
Year
{10 lbs beef, 20 lbs chicken} Beef Chicken

The CPI basket cost $120 2015 $4 $4

in 2015, the base year. 2016 $5 $5

2017 $9 $6

B. What was the inflation rate from 2016-2017?

Cost of CPI basket in 2017
= ($9 x 10) + ($6 x 20) = $210
CPI in 2017 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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WHAT’S IN THE CPI’S BASKET?

4% 3% Housing
6%
Transportation
6%
Food & Beverages
6% 43%
Medical care

Recreation

Education and
15%
communication
Apparel

17% Other
ACTIVE LEARNING 2
SUBSTITUTION BIAS
CPI basket: Cost Of CPI
Beef Chicken
Basket
{10# beef, 20# chicken}
2015 $4 $4 $120
2015 - 2016: 2016 $5 $5 $150
Households bought CPI basket.2017 $9 $6 $210

2017: Households bought {5 lbs beef, 25 lbs

chicken}.

A. Compute cost of the 2017 household basket.

B. Compute % increase in cost of household basket
over 2016 - 2017, compare to CPI inflation rate.
11
ACTIVE LEARNING 2
Answers

CPI basket:
Cost Of CPI
{10# beef, 20# chicken} Beef Chicken
Basket
Household basket in 2017: 2015 $4 $4 $120
{5# beef, 25# chicken} 2016 $5 $5 $150
2017 $9 $6 $210

A. Compute cost of the 2017 household basket.

($9 x 5) + ($6 x 25) = $195

12
ACTIVE LEARNING 2
Answers

Cost Of CPI
CPI basket: Beef Chicken
Basket
{10# beef, 20# chicken} 2015 $4 $4 $120
Household basket in 2017: 2016 $5 $5 $150
{5# beef, 25# chicken} 2017 $9 $6 $210

B. Compute % increase in cost of household basket

over 2005-6, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI inflation rate from previous problem = 40%
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 PROBLEMS WITH THE CPI:
SUBSTITUTION BIAS

• Over time, some prices rise faster than others.

• Consumers substitute toward goods that become

relatively cheaper.

• The CPI misses this substitution because it uses a fixed

basket of goods.

• Thus, the CPI overstates increases in the cost of living.

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 PROBLEMS WITH THE CPI:
INTRODUCTION OF NEW GOODS

• The introduction of new goods increases variety, allows

consumers to find products that more closely meet their
needs.

• In effect, dollars become more valuable.

• The CPI misses this effect because it uses a fixed basket

of goods.

• Thus, the CPI overstates increases in the cost of living.15

 PROBLEMS WITH THE CPI:
UNMEASURED QUALITY CHANGE

• Improvements in the quality of goods in the basket

increase the value of each dollar.

• The BLS tries to account for quality changes

but probably misses some, as quality is hard to
measure.

• Thus, the CPI overstates increases in the cost of

living. 16
 PROBLEMS WITH THE CPI
• Each of these problems causes the CPI to overstate
cost of living increases.

• The BLS has made technical adjustments, but the CPI

probably still overstates inflation by about 0.5 percent
per year.

• This is important because Social Security payments

and many contracts have COLAs tied to the CPI.
MEASURING THE COST OF LIVING 17
TWO MEASURES OF INFLATION, 1965
- 2020

MEASURING THE COST OF LIVING 18

 CORRECTING VARIABLES FOR INFLATION:
COMPARING DOLLAR FIGURES FROM DIFFERENT TIMES

• Inflation makes it harder to compare dollar amounts from

different times.

• Example: the minimum wage

• $1.15 in Dec 1985

• $5.85 in Dec 2020

• Did min wage have more purchasing power in

Dec 1965 or Dec 2020?

• To compare, use CPI to convert 1965 figure into “today’s

dollars”…
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 CORRECTING VARIABLES FOR INFLATION:
COMPARING DOLLAR FIGURES FROM DIFFERENT TIMES

Amount
Amount Price level today
in
= in year T x Price level in year
today’s
dollars T
dollars
• In our example,
• Year T = 12/1985, “today” = 12/2020
• Minimum wage = $1.15 in year T
• CPI = 31.3 in year T, CPI = 211.7 today

The minimum wage 211.

$1.1 x
in 1964 was $7.78 $7.78 = 7
5 31.3
in today’s (2007)
dollars. 20
 CORRECTING VARIABLES FOR INFLATION:
COMPARING DOLLAR FIGURES FROM DIFFERENT TIMES

• Researchers, business analysts and policymakers

often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar
(real) figures.

• They can then see how a variable has changed over

time after correcting for inflation.

• Example: the minimum wage, from Jan 1950 to Dec

21
2007…
 THE U.S. MINIMUM WAGE IN CURRENT DOLLARS
AND TODAY’S DOLLARS, 1965-2020

$9

$8 2020
$ per hour
dollars
$7

$6

$5

$4

$3

$2 current
$1
dollars

$0
196519701975198019851990199520002005201020152020
ACTIVE LEARNING 4
CONVERTING TO “TODAY’S DOLLARS”
Annual tuition and fees, average of all public four-year
colleges & universities in the U.S.
• 2001-2022: $1,414 (2001 CPI = 109.6)
• 2021-2022: $5,834 (2021 CPI = 203.8)

After adjusting for inflation, did students pay more for

college in 2001 or in 2021? Convert the 2001 figure
to 2021 dollars and compare.
ACTIVE LEARNING 4
ANSWERS
Annual tuition and fees, average of all public
four-year colleges & universities in the U.S.
• 2001-2002: $1,414 (2001 CPI = 109.6)
• 2021-2022: $5,834 (2021 CPI = 203.8)

Solution
Convert 2001 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 2001 than in 2021!
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 CORRECTING VARIABLES FOR INFLATION:
INDEXATION

A dollar amount is indexed for inflation

if it is automatically corrected for inflation
by law or in a contract.

For example, the increase in the CPI

automatically determines
• the COLA in many multi-year labor contracts

• the adjustments in Social Security

payments and federal income tax brackets
 CORRECTING VARIABLES FOR INFLATION:
REAL VS. NOMINAL INTEREST RATES

The nominal interest rate:

• the interest rate not corrected for inflation

• the rate of growth in the dollar value of a

deposit or debt

The real interest rate:

• corrected for inflation

• the rate of growth in the purchasing power of a deposit or debt

Real interest rate

= (nominal interest rate) – (inflation rate) 26
 CORRECTING VARIABLES FOR INFLATION:
REAL VS. NOMINAL INTEREST RATES

Example:
• Deposit $1,000 for one year.
• Nominal interest rate is 9%.
• During that year, inflation is 3.5%.
• Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
• The purchasing power of the $1000 deposit
has grown 5.5%.

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REAL AND NOMINAL INTEREST RATES IN THE U.S.,
1965-2020

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THINK-PAIR-SHARE ACTIVITY
Your grandfather quit smoking cigarettes in 1995. When you ask him why he quit,
you get a surprising answer. Instead of reciting the health benefits of quitting
smoking, he says, “I quit because it was just getting too expensive. I started
smoking in 1965 in Vietnam and cigarettes were only 45 cents a pack. The last
pack I bought was $2.00 and I just couldn’t justify spending more than four times
as much on cigarettes as I used to.”

A. In 1965, the CPI was 31.5. In 1995, the CPI was 152.4. While it is commendable
that your grandfather quit smoking, what is wrong with his explanation?

B. What is the equivalent cost of a 1965 pack of cigarettes measured in 1995

prices?

C. What is the equivalent cost of a 1995 pack of cigarettes measured in 1965

SELF-ASSESSMENT
• Does an increase in the price of imported goods affect
the CPI or the GDP deflator more? Why?
CHAPTER SUMMARY
• The Consumer Price Index is a measure of the cost of
living. The CPI tracks the cost of the typical consumer’s
“basket” of goods & services.

• The CPI is used to make Cost of Living Adjustments and to

correct economic variables for the effects of inflation.

• The real interest rate is corrected for inflation

and is computed by subtracting the inflation rate from the
nominal interest rate.
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