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CHAPTE
R

Measuring the Cost of Living

Economics
PRINCIPLES OF

N. Gregory
Mankiw
Premium PowerPoint Slides
by Ron Cronovich 2011
© 2011 South-Western, a part of Cengage Learning, all rights reserved update
In this chapter,
look for the answers to these questions:

• 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)

• measures the typical consumer’s cost of living

• the basis of cost of living adjustments (COLAs) in many
contracts and in Social Security

MEASURING THE COST OF LIVING 3

 Inflation: the overall
price level
▪ The overall price level is an index of a comprehensive basket of goods and
services (42,000 items)
▪ The inflation rate is the speed with which the overall price level is
changing.

▪ A rapidly rising price level, hyperinflation, is VERY DESTABILIZING

▪ A Rapidly falling price level, deflation, is VERY DESTABILIZING

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5
So much fuss about
inflation…
▪ “Inflation destroys savings, impedes planning, and discourages
investment.
That means less productivity and a lower standard of living”. -
Kevin Brady
▪ The way to crush the bourgeoisie is to grind them between
the millstones of taxation and inflation. Vladimir Lenin
▪ By a continuing process of inflation, government can confiscate,
secretly and
unobserved, an important part of the wealth of their citizens. John
Maynard 6
Keynes
▪ Inflation is as violent as a mugger, as frightening as an armed
robber and as deadly as a hit man. Ronald Reagan
Hyperinflation: Weimar Germany, 1918-1923 from 1
to 1 trillion paper Marks for 1 gold mark

7
Deflation During the Great Depression:
Prices Fell by 37%, And Bankruptcies
Soared

8
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.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the basket.
MEASURING THE COST OF LIVING 9
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 year
100 x
cost of basket in base year
5. Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
Inflation CPI this year – CPI last year
= x 100%
rate CPI last year
MEASURING THE COST OF LIVING 10
EXAMPLE basket: {4 pizzas, 10 lattes}

price of price of
year cost of basket
pizza latte
2007 $10 $2.00 $10 x 4 + $2 x 10 = $60
2008 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2009 $12 $3.00 $12 x 4 + $3 x 10 = $78

Compute CPI in each year Inflation rate:

using 2007 base year:
2007: 100 x ($60/$60) = 100 115 – 100
15% = x 100%
100
2008: 100 x ($69/$60) = 115
130 – 115
2009: 100 x ($78/$60) = 130 13% = x 100%
115

MEASURING THE COST OF LIVING 11

ACTIVE LEARNING 1
Calculate the CPI
price price of
CPI basket: of beef chicken
{10 lbs beef, 2004 $4 $4
20 lbs chicken}
2005 $5 $5
The CPI basket cost $120
in 2004, the base year. 2006 $9 $6

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

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ACTIVE LEARNING 1
Answers
price price of
CPI basket: of beef chicken
{10 lbs beef, 2004 $4 $4
20 lbs chicken}
2005 $5 $5
The CPI basket cost $120
in 2004, the base year. 2006 $9 $6

A. Compute the CPI in 2005:

Cost of CPI basket in 2005
= ($5 x 10) + ($5 x 20) = $150
CPI in 2005 = 100 x ($150/$120) = 125
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ACTIVE LEARNING 1
Answers
price price of
CPI basket: of beef chicken
{10 lbs beef, 2004 $4 $4
20 lbs chicken}
2005 $5 $5
The CPI basket cost $120
in 2004, the base year. 2006 $9 $6

B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006
= ($9 x 10) + ($6 x 20) = $210
CPI in 2006 = 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

MEASURING THE COST OF LIVING 15

ACTIVE LEARNING 2
Substitution bias
CPI basket: cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 $4 $4 $120
2004-5:
2005 $5 $5 $150
Households
bought CPI basket. 2006 $9 $6 $210

2006: Households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2006 household basket.

B. Compute % increase in cost of household basket
over 2005-6, compare to CPI inflation rate.
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ACTIVE LEARNING 2
Answers
CPI basket: cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 $4 $4 $120
Household
basket in 2006: 2005 $5 $5 $150
{5# beef, 2006 $9 $6 $210
25# chicken}

A. Compute cost of the 2006 household basket.

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

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ACTIVE LEARNING 2
Answers
CPI basket: cost of CPI
{10# beef, beef chicken
basket
20# chicken}
2004 $4 $4 $120
Household
basket in 2006: 2005 $5 $5 $150
{5# beef, 2006 $9 $6 $210
25# chicken}
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, mitigating the effects of price
increases.
• The CPI misses this substitution because it uses a fixed
basket of goods.
• Thus, the CPI overstates increases in the cost of living.

MEASURING THE COST OF LIVING 19

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.

MEASURING THE COST OF LIVING 20

 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.

MEASURING THE COST OF LIVING 21

 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 22

Food and Energy (oil) –
the real culprits!

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Pakistan’s inflation rate

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Two Measures of Inflation, 1950-2010
15

10
Percent per year

-5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI GDP deflator

 Contrasting the CPI and GDP Deflator
Imported
Importedconsumer
consumergoods:
goods:
•• included
includedin
inCPI
CPI
•• excluded
excludedfrom
fromGDP
GDPdeflator
deflator
Capital
Capital goods:
goods:
 excluded
excluded from
from CPI
CPI
 included
included in
in GDP
GDP deflator
deflator
The
The basket:
basket: (if
(if produced
produced domestically)
domestically)
 CPI
CPI uses
uses fixed
fixed basket
basket
 GDP
GDP deflator
deflator uses
uses basket
basket of
of
currently
currently produced
produced goods goods && services
services
This
This matters
matters ifif different
different prices
prices are
are
changing
changing byby different
different amounts.
amounts.
MEASURING THE COST OF LIVING 27
ACTIVE LEARNING 3
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial tractors
it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it sells in
the U.S.

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ACTIVE LEARNING 3
Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial tractors
it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it sells in
the U.S.
The CPI rises, the GDP deflator does not.

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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 1964
• $7.25 in Dec 2010
• Did min wage have more purchasing power in
Dec 1964 or Dec 2010?
• To compare, use CPI to convert 1964 figure into “today’s
dollars”…

MEASURING THE COST OF LIVING 30

Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times

Amount Amount Price level today

in today’s = in year T x
dollars dollars Price level in year T

• In our example,
• “year T” is 12/1964, “today” is 12/2010
• Min wage was $1.15 in year T
• CPI = 31.3 in year T, CPI = 220.3 today

The minimum wage 220.3

in 1964 was $8.09 $8.09 = $1.15 x
31.3
in today’s (2010) dollars.
MEASURING THE COST OF LIVING 31
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
2010…

MEASURING THE COST OF LIVING 32

The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1960-2010
$12.00

2010 dollars
$10.00
Dollars per hour

$8.00

$6.00

$4.00

$2.00
current dollars

$0.00
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
ACTIVE LEARNING 4
Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2010
Private non-profit 4-year $9,340 $27,293

Public 4-year $1,908 $7,605

Public 2-year $906 $2,713

CPI 130.7 218.1

Instructions: Express the 1990 tuition figures in 2010

dollars, then compute the percentage increase for all
three types of schools. Which type experienced the
largest increase in real tuition costs?
ACTIVE LEARNING 4
Answers
1990 2010 % change
CPI 130.7 218.1 66.9%
Private non-profit 4-year
(current $) $9,340 $27,293

Private non-profit 4-year

(2010 $) $15,586 $27,293 75.1%

Public 4-year (current $) $1,908 $7,605

Public 4-year (2010 $) $3,184 $7,605 138.9%

Public 2-year (current $) $906 $2,713

Public 2-year (2010 $) $1,512 $2,713 79.4%

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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
• adjustments in Social Security payments and federal
income tax brackets

MEASURING THE COST OF LIVING 36

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)

MEASURING THE COST OF LIVING 37

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%.

MEASURING THE COST OF LIVING 38

Real and Nominal Interest Rates in the U.S.,
1950-2010
Cost of inflation
▪ Shoe leather costs
▪ Menu costs
▪ Redistributive costs
▪ Shifting purchasing power
▪ Lending and borrowing
concerns

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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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