Transcript Chapter 11
Chapter 11
Measuring the Cost of Living
Outline
Construction of CPI
Calculation of CPI and the Inflation Rate
Problems in measuring CPI
GDP Deflator versus CPI
Correcting economic variables for the
effects of inflation
Indexation
Real and Nominal interest rates
CPI
The Consumer Price Index (CPI) is a measure
of the overall cost of the goods and services
bought by a typical consumer.
CPI measures changes in the cost of living
over time.
CPI estimates by how much incomes must rise
to maintain a constant standard of living.
CPI reflects the purchasing power of the
currency
It reports the movement of prices with an index
number.
Calculating CPI: Various Steps
1. Fix the Basket: Identify the basket of goods
consumed by a 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: Calculate the cost
of the basket of goods and services at different
times
4. Choose a base year and compute the index:
Designate one year as the base year.
CPI= (price of basket in current year/ price of
basket in base year)x100
Calculating CPI: Various Steps
5. Calculate the Inflation Rate: Use the CPI to
calculate the inflation rate.
Inflation rate is the percentage change in the
price index from the preceding period.
What’s in the CPI’s Basket?
Household
10.0%
Recreation
10.4%
Clothing
6.6%
Alcohol
4.5% Health
4.3%
Shelter
27.9%
Food
18.0%
Transportation
18.3%
CPI Monthly Index: Nov 2003
Canada
Same month last year
Previous
month
Nov-03
Change from
previous month
1992 = 100
Change from
same month last
year
%
All items
120.8
122.4
122.7
0.2
1.6
Food
120.4
121.1
122.3
1
1.6
Shelter
115.7
118.2
118.3
0.1
2.2
114
115.1
114.9
-0.2
0.8
Clothing and footwear
105.2
105
104.2
-0.8
-1
Transportation
139.2
139.7
140.9
0.9
1.2
Health and personal care
116.2
117.7
118
0.3
1.5
Recreation, education and reading
126.7
128.3
127.5
-0.6
0.6
Alcoholic beverages and tobacco products
131.9
137
137.6
0.4
4.3
121
122.7
122.8
0.1
1.5
All items excluding energy
119.4
121.1
121.6
0.4
1.8
Energy
136.2
137
135.4
-1.2
-0.6
Household operations and furnishings
Special aggregates
All items excluding food
Source: Statistics Canada, CANSIM, table 326-0001 and Catalogue nos. 62-001-XPB and 62-010-XIB.
Problems in Measuring The Cost of
Living
The CPI is not a perfect measure of the “cost of
living.”
Three reasons/problems:
Substitution Bias: Consumers substitute toward
goods that have become relatively less expensive
Introduction of new goods: With greater variety
consumers need fewer dollars to maintain any
given standard of living
Unmeasured quality change: Quality impacts on
the value of the currency
The Consumer Price Index versus the GDP
Deflator
The CPI:
includes only consumption goods
includes the cost of imports
is a fixed bundle of goods
The GDP Price Deflator:
includes all final goods and services
excludes imports
uses a current bundle of goods
Correcting Economic Variables for the Effects of
Inflation
To convert (inflate) past wages and prices
into current terms:
Current Year Dollars =
Past Year Nominal Value X [(Price index in current year) ÷
(Price index in past year)]
Correcting Economic Variables for the Effects of
Inflation
To convert (deflate) current wages and
prices into past year terms:
Value in Past Year Dollars =
Current Year Value X [(Price index in past year) ÷ (Price
index in current year)]
Indexation
Indexation is the automatic correction of a
dollar amount for the effects of inflation by law
or contract. E.g., COLA
Real interest rate= Nominal interest rateInflation rate
Inflation in Canada: CPI inflation