Measuring the Cost of

Living

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 Measuring the Cost of Living

 Inflation refers to a situation in which the

economy’s overall price level is rising.
 The inflation rate is the percentage
change in the price level from the
previous period.

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 Using Price Indexes
 Because inflation may overstate the value
of our GDP we need to make adjustments
accordingly.
 A price index is a measurement of how
the average price of a standard group of
goods changes over time.
 Price indexes are the way we adjust
nominal GDP (the value of GDP in
current dollars) to real GDP (the value of
GDP in constant dollars)
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 Consumer Price Index
 The consumer price
index (CPI) is a measure
of the overall cost of the
goods and services
bought by a typical
consumer.
 The consumer price
index uses a “fixed
basket of goods” and
evaluates changes in the
basket’s costs each
month.
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 Calculating a Price Index
Price Index in given year =
Cost of market basket in a given year X 100
Cost of market basket in base year

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 The Bureau of Labor Statistics reports the CPI each month

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 Current changes in the CPI

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 Does the CPI overstate Inflation?
 Two reasons why it might:
 The CPI uses a fixed basket of goods. If the price
of a good in the basket rises, the CPI rises. In
reality, if the price of a good rises consumers
typically substitute in a cheaper good.
 The CPI does not take into account the value of
innovation and the improvements in technology we
enjoy. A $2000 computer from 1990 is not the
same as a $2000 computer today.

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 Other Price Indexes
 The BLS calculates other prices indexes:
 The indices for different regions within the
country.

 The producer price index, which measures the cost

of a basket of goods and services bought by firms
rather than consumers. This index is a leading
indicator of future price increases for consumers.

 The GDP deflator

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 The GDP deflator allows us to distinguish
between nominal GDP, which
measures prices and quantities, and real
GDP, which measures just quantities.

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP

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 How the Consumer Price Index Is Calculated

1. Fix the Basket: Determine what

prices are most important to the
typical consumer.
2. Find the Prices: Find the prices of
each of the goods and services in the
basket for each point in time.
3. Compute the Basket’s Cost: Use the
data on prices to calculate the cost of
the basket of goods and services at
different times.

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 How the Consumer Price Index Is
Calculated
4. Choose a Base Year and Compute the Index:
 Designate one year as the base year, making

it the benchmark against which other years

are compared.
 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

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 The Inflation Rate
 We use the Consumer Price Index to calculate the
inflation rate.
 Compute the inflation rate: The inflation rate is
the percentage change in the price index from the
preceding period.
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year2   100
CPI in Year 1

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 Causes of inflation
 Demand Pull Theory – demand for
goods & services exceeds existing
supply. One reason for this may be
too much money in circulation.
 Cost Push Theory- producers raise
prices in order to meet increased
costs. This is also known as supply
shocks (supply curve shifts left).

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 Demand-pull Cost-push or Supply
Shock

AS2
P P AS1
R R
I AS
I
C C
E E
L L
E E
V V
E E
L AD1 AD2 L AD

REAL GDP REAL GDP

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 Effects of Inflation
Interest Rates:
•Interest represents a payment in the
future for a transfer of money in the
past.
•When you save or loan someone
money you expect a return on that
money (interest).
•Inflation affects the future value of
our money.
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 Real and Nominal Interest Rates
 The nominal interest rate is the interest
rate not corrected for inflation.
 It is the stated interest rate that a bank pays.
 The real interest rate is the nominal
interest rate that is corrected for
inflation. When evaluating your return
you need to focus on the real interest rate
Real interest rate = (Nominal interest rate –
Inflation rate)

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 Real and Nominal Interest Rates

 You borrowed $1,000 for one year.

 Nominal interest rate was 15%.
 During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%

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 Anticipated and Unanticipated
Inflation
 If a bank anticipates inflation they will
set the nominal rate high enough to
insure a return on any loans they make
and inflation will not harm them.
 If inflation is unanticipated then the
interest rate will not be set high enough
and the bank (savers) will lose money.

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 Real and Nominal Interest Rates
Interest Rates
(percent per
year)
15
Nominal
interest rate
10

Real interest rate

-5
1965 1970 1975 1980 1985 1990 1995 1998
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 Who’s Hurt? Who’s Helped?
By Unanticipated Inflation
You’re hurt if you are a You’re helped if you are a
 Creditor – the money  Borrower- the money you

you loan out is worth less are repaying is worth less

when its paid back  Flexible income earner-
 Saver – inflation rates  if your income is tied to
are normally higher than profits you will earn more
interest rates  If your income is adjusted
 Fixed income receiver- a
for inflation you will earn
more (COLA)
constant income will buy  Payer of fixed amounts
less.

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