Measuring the Cost of Living

Measuring the Cost of Living: The Consumer

Price Index (CPI)
 The increase in the overall level of prices is called inflation.
➢ The percentage change in the price level from one period to
the next is called the inflation rate.
 The most commonly used measure of the level of prices is the
consumer price index (CPI).
 Published by the Bureau of Labor Statistics (BLS) in US
 In Bangladesh, by the Bangladesh Bureau of Statistics (BBS)
 Uses:
 tracks changes in the typical household’s cost of living

 adjusts many contracts for inflation (“COLAs: Cost-of-Living

Adjustment”)
 allows comparisons of dollar amounts over time
The Price of a Basket of Goods
How the BLS constructs the CPI
1. Survey consumers to determine composition of the typical
consumer’s “basket” of goods.
2. Every month, collect data on prices of all items in the basket;
compute cost of basket
3. CPI in any month equals

Cost of basket in that month

100 
Cost of basket in base period

➢ The index tells us how much it costs now to buy a basket of

goods relative to how much it cost to buy the same basket
of goods in the base period.
Exercise: Compute the CPI
Basket contains 20 pizzas and 10 compact discs.

prices: For each year, compute

pizza CDs ▪ the cost of the basket
2014 $10 $15 ▪ the CPI (use 2014 as the
2015 $11 $15 base year)
2016 $12 $16 ▪ the inflation rate from the
2017 $13 $15 preceding year
Answers:
Cost of Inflation
basket CPI rate
2014 $350 100.0 n.a.
2015 370 105.7 5.7%
2016 400 114.3 8.1%
2017 410 117.1 2.5%
The composition of the CPI’s “basket”
Food and bev. 6.2%
17.4% 5.6%
Housing
3.0%
Apparel 3.1%
3.8%
Transportation 3.5%

Medical care

Recreation

Education 15.1%

Communication

Other goods 42.4%

and services
The composition of the CPI’s “basket” in Bangladesh
 Reasons why the CPI may overstate inflation

 Substitution bias: The CPI uses fixed weights,

so it cannot reflect consumers’ ability to substitute
toward goods whose relative prices have fallen.
 Introduction of new goods: The introduction of new
goods makes consumers better off and, in effect,
increases the real value of the dollar. But it does not
reduce the CPI, because the CPI uses fixed weights.
 Unmeasured changes in quality:
Quality improvements increase the value of the
dollar, but are often not fully measured.
The size of the CPI’s bias
 In 1995, a Senate-appointed panel of experts
estimated that the CPI overstates inflation by about
1.1% per year.
 So the BLS made adjustments to reduce the bias.
 Now, the CPI’s bias is probably under 1% per year.
 CPI vs. GDP Deflator
▪ GDP deflator measures the prices of all goods and services
produced.
▪ CPI measures the prices of only the goods and services bought
by consumers.
prices of goods bought only by firms or the government
 included in GDP deflator (if produced domestically)
 excluded from CPI
prices of imported consumer goods
 included in CPI
 excluded from GDP deflator
the basket of goods
 CPI: fixed
 GDP deflator: changes every year
Topic 8b: Measuring Joblessness: The
Unemployment Rate
The Household Survey

Adult population is classified into 3 categories:

Employed, Unemployed, Not in labor force
 labor force
the amount of labor available for producing goods and
services; all employed plus unemployed persons
 employed
working at a paid job
 unemployed
not employed but looking for a job
 not in the labor force
not employed, not looking for work
Two important labor force concepts
 unemployment rate
percentage of the labor force that is unemployed
 labor force participation rate
the fraction of the adult population
that “participates” in the labor force
Important labor force concepts
The Three Groups of the Population
 Exercise:
Compute labor force statistics
U.S. adult population by group, June 2006
Number employed = 144.4 million
Number unemployed = 7.0 million
Adult population = 228.8 million

Use the above data to calculate

– the labor force
– the number of people not in the labor force
– the labor force participation rate
– the unemployment rate
Answers:
 data: E = 144.4, U = 7.0, POP = 228.8
 labor force
L = E +U = 144.4 + 7 = 151.4
 not in labor force
NILF = POP – L = 228.8 – 151.4 = 77.4
 unemployment rate
U/L x 100% = (7/151.4) x 100% = 4.6%
 labor force participation rate
L/POP x 100% = (151.4/228.8) x 100% =
66.2%
What Does the U-Rate Really Measure?
The u-rate is not a perfect indicator of joblessness or
the health of the labor market:
1. It excludes discouraged workers.
2. It does not show underemployment.
3. It cannot account for misreporting of status.

UNEMPLOYMENT 17
Cyclical Unemployment vs. the Natural Rate
There’s always some unemployment, though the
u-rate fluctuates from year to year.
Natural rate of unemployment
▪ the normal rate of unemployment around which
the actual unemployment rate fluctuates
Cyclical unemployment
▪ the deviation of unemployment from its
natural rate
▪ associated with the business cycle

UNEMPLOYMENT 18
 U.S. Unemployment, 1960-2007
12

Unemployment rate
percentage of labor force

10

4 Natural rate of
unemployment
2

0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Explaining the Natural Rate: An Overview
Even when the economy is doing well, there is always some
unemployment, including:
Frictional unemployment
▪ occurs when workers spend time searching for the jobs that
best suit their skills and tastes
▪ short-term for most workers
▪ potential reasons: job search and sectoral shifts
▪ policy solutions?
Structural unemployment
▪ occurs when there are fewer jobs than workers
▪ usually longer-term
▪ potential reasons: minimum wage laws, unions, efficiency
wages
UNEMPLOYMENT 20
 Job Search & Frictional Unemployment
▪ frictional unemployment: caused by the
time it takes workers to search for a job
▪ occurs even when wages are flexible and
there are enough jobs to go around
▪ occurs because
▪ workers have different abilities, preferences
▪ jobs have different skill requirements
▪ geographic mobility of workers not
instantaneous
▪ flow of information about vacancies and job
candidates is imperfect

UNEMPLOYMENT 21
 Sectoral shifts
▪ def: changes in the composition of demand
among industries or regions
▪ example: Technological change
increases demand for computer repair persons,
decreases demand for typewriter repair persons
▪ example: A new international trade agreement
causes greater demand for workers in the export
sectors and less demand for workers in import-
competing sectors.
▪ It takes time for workers to change sectors,
so sectoral shifts cause frictional unemployment.
UNEMPLOYMENT 22
 Explaining Structural Unemployment

Structural unemp-
unemployment W loyment S
occurs when not actual
W1
wage
enough jobs to
go around. WE
Occurs when wage
is kept above
equilibrium.
D
L

UNEMPLOYMENT 23
 Reasons for wage rigidity

1. Minimum wage laws

2. Labor unions

3. Efficiency wages (employers offer high wage

as incentive for worker productivity and loyalty)

UNEMPLOYMENT 24
 The minimum wage
▪ The minimum wage is well below the eq’m
wage for most workers, so it cannot explain
the majority of natural rate unemployment.
▪ However, the minimum wage may exceed
the eq’m wage of unskilled workers,
especially teenagers.
▪ If so, then we would expect that increases in
the minimum wage would increase
unemployment among these groups.

UNEMPLOYMENT 25
 The minimum wage in the real world:
▪ In Sept 1996, the minimum wage was raised
from $4.25 to $4.75. Here’s what happened:

Unemployment rates, before & after

3rd Q 1996 1st Q 1997
Teenagers 16.6% 17.0%
Single
8.5% 9.1%
mothers
All workers 5.3% 5.3%
▪ Other studies: A 10% increase in the minimum
wage increases teenage unemployment by 1-3%.
UNEMPLOYMENT 26
 Labor unions
▪ Unions exercise monopoly power to secure
higher wages for their members.
▪ When the union wage exceeds the eq’m
wage, unemployment results.
▪ Employed union workers are insiders
whose interest is to keep wages high.
▪ Unemployed non-union workers are
outsiders and would prefer wages to be
lower (so that labor demand would be high
enough for them to get jobs).
UNEMPLOYMENT 27
Efficiency Wages
Four reasons why firms might pay efficiency wages:
1. Worker health
2. Worker turnover
3. Worker quality
4. Worker effort

UNEMPLOYMENT 28
 Public Policy and Job Search

Govt programs affecting unemployment

▪ Govt employment agencies:
disseminate info about job openings to better
match workers & jobs
▪ Public job training programs:
help workers displaced from declining
industries get skills needed for jobs in
growing industries

UNEMPLOYMENT 29
 Unemployment insurance (UI)

▪ UI pays part of a worker’s former wages for a

limited time after losing his/her job.
▪ UI increases search unemployment, because it:
– reduces the opportunity cost of being
unemployed
– reduces the urgency of finding work
– hence, reduces f
▪ Studies: The longer a worker is eligible for UI,
the longer the duration of the average spell of
unemployment.

UNEMPLOYMENT 30
 Benefits of UI

▪ By allowing workers more time to search,

UI may lead to better matches between
jobs and workers,
which would lead to greater productivity
and higher incomes.

UNEMPLOYMENT 31
Chapter Summary
4. The overall level of prices can be measured by
either
 the Consumer Price Index (CPI),
the price of a fixed basket of goods
purchased by the typical consumer, or
 the GDP deflator,
the ratio of nominal to real GDP
5. The unemployment rate is the fraction of the
labor force that is not employed.
 Summary

▪ The unemployment rate is the percentage of those

who would like to work who do not have jobs.
▪ Unemployment and labor force participation vary
widely across demographic groups.
▪ The natural rate of unemployment is the normal
rate of unemployment around which the actual rate
fluctuates. Cyclical unemployment is the deviation
of unemployment from its natural rate and is
connected to short-term economic fluctuations.
33
 Summary

▪ The natural rate includes frictional unemployment

and structural unemployment.
▪ Frictional unemployment occurs when workers
take time to search for the right jobs.
▪ Structural unemployment occurs when above-
equilibrium wages result in a surplus of labor.
▪ Three reasons for above-equilibrium wages include
minimum wage laws, unions, and efficiency wages.

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Thank You!