Measuring The Cost of Living: Aman 22 February 2013

Measuring the cost of living
Aman 22 February 2013

Inflation refers to a situation in which the economys overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

The consumers price index
The consumers price index (CPI) is a measure of the overall cost of the goods and services bought by a typical household. Pakistan Bureau of Statistics reports the CPI each month. It is used to monitor changes in the cost of living over time.
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When the CPI rises, the typical family has to spend more Rupees/dollars to maintain the same standard of living.

How the CPI is calculated
In calculating the consumers price index, Pakistan Bureau of Statistics uses data on over 487 items (goods and services). Consider a simple economy in which consumers only buy two goods: Burger and Soft drink. Five steps are followed to estimate the CPI and inflation.

1 Fix the basket Determine what prices are most important to the typical consumer.
Statistics Bureau identifies a market basket of goods and services the typical consumer buys.
They then conduct monthly consumer surveys to set the weights for the prices of those goods and services.

Find the prices Find the prices of each of the goods and services in the basket for each point in time.

Compute the baskets cost Use the data on prices to calculate the cost of the basket of goods and services at different times.

4 Choose a base period and compute the index Once the base year is chosen, the CPI may be calculated as follows.
CPI =
Price of basket of goods and services in current year

Price of basket of goods and services in base year
X 1000

Calculate the inflation rate

Inflation rate =
(CPI in Year 2) (CPI in Year 1)
X 100
CPI in Year 1
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Example of calculating the consumers price index and the inflation rate
Step 1: Survey consumers to determine a fixed basket of goods Basket = 4 cans of Pepsi, 2 burgers Step 2: Find the price of each good in each year Year 2009 Price of Pepsi (Rs.) 10 Price of Burgers (Rs.) 100
2010
2011
15
20
200
300
Step 3: Compute the cost of the basket of goods in each year Step 4: Choose one year as a base year (2008) and compute the consumer price index in each year Step 5: Use the consumer price index to compute the inflation rate from previous year

FYI: What is in the CPIs basket?
When constructing the basket, Statistics Bureau tries to include goods and services most frequently used by the average consumer, weighted by how much consumers use each item.
Restaurants & Hotels 1% Recreation & Education Culture 4% 2% Communication 3%
The typical basket of goods and services

Miscellaneous Goods & Services 3%
Health 2% Furnishing & Household Equipment Maintenance 4%
Transport 7%
Food & NonAlcoholic Beverages 35%
Housing, Water, Electricity, Gas and Other Fuels 29%
Clothing & Footwear 8%
Alcoholic Beverage, Tobacco 2%

An example of calculating the consumers price index:
base year is 2002 basket of goods in 2002 costs Rs.1200 the same basket in 2004 costs Rs.1236 CPI = (Rs.1236/Rs.1200) 1000 = 1003 prices increased 3 percent between 2002 and 2004.
CPI_PBS.pdf
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Problems in measuring the cost of living
The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.
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1 Substitution bias
2 Introduction of new goods 3 Unmeasured quality changes
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1 Substitution bias
The basket does not change to reflect consumer reaction to changes in relative prices. Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution.
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2 Introduction of new goods
The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each Rupee/dollar more valuable. Consumers need fewer Rupees/dollars to maintain any given standard of living.
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3 Unmeasured quality changes
If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. Pakistan Bureau of Statistics tries to adjust the price for constant quality, but such differences are hard to measure.
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The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.
The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. The CPI overstates true inflation.
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THE CONSUMER PRICE INDEX

When the CPI rises, the typical family has to spend more Rupees/dollars to maintain the same standard of living. You can download the CPI data from the website of the Pakistan Bureau of Statistics :
http://pbs.gov.pk/content/price-statistics
Base: June 2007-08= 100
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15
20
25
30
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Pak. Time Series for the CPI

(Pakistan Bureau of Statistics)
Consumer Price Index
1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Measuring inflation
The GDP deflator
The GDP deflator is calculated as follows:
Nominal GDP Real GDP
GDP deflator =
x 1000
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Measuring inflation
The GDP deflator versus the CPI
Economists and policymakers monitor both the GDP deflator and the consumers price index to gauge how quickly prices are rising. There are two important differences between the indexes that can cause them to diverge.
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Two measures of inflation

30 GDP deflator 25 Consumer Price Index
20
15
10
0 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
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Measuring inflation
The GDP deflator reflects the prices of all goods and services produced domestically, whereas the consumers price index reflects the prices of all goods and services bought by consumers.
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Measuring inflation
The consumers price index compares the price of a fixed basket of goods and services to the price of the basket in the base year.
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Measuring inflation
Whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.
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Correcting economic variables for the effects of inflation

Price indexes are used to correct for the effects of inflation when comparing Rupee/dollar figures from different times. Take a mason in 1960. They would have earned the equivalent of Rs.15 per week. A price index can help establish what earnings would be relative to todays prices.
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Our masons wage today can be calculated using the following general price index formula.
Amount in todays Rupees= Price level today
Amount in year T dollars
Price level in year T
Specifically:
Price level in 2012 Wage in 2012 Rupees =
Price level in 1960
Wage in 1960 Rupees

Although our mason made only Rs. 15 per week in 1960, in todays Rupees they would be earning Rs. 185.49 about what we would expect a mason to earn today. Some questions to consider:
Has the average persons purchasing power changed over the last 50 years? Has the standard of living actually improved since 1960?
Indexation
When some Rupees/Dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. Superannuation contributions, for instance, may be indexed. Each year the contribution increases to account for rising prices inflation.
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Real and nominal interest rates

The nominal interest rate is the interest rate usually reported and not corrected for inflation. Quoted bank rates are nominal.
The real interest rate is the nominal interest rate that is corrected for the effects of inflation.
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Real and Nominal Interest Rates

You borrowed Rs.100,000 for one year. Nominal interest rate was 15%. During the year inflation was 10%. Real interest rate = Nominal interest rate Inflation = 15% - 10% = 5%
Summary
The consumers price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate.
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Summary
The consumers price index is an imperfect measure of the cost of living for the following three reasons: Substitution bias, the introduction of new goods and unmeasured changes in quality.
Because of measurement problems, the CPI overstates true inflation.
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Summary
The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed.
In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.
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Summary
Dollar figures from different points in time do not represent a valid comparison of purchasing power. Various laws and private contracts use price indexes to correct for the effects of inflation. The real interest rate equals the nominal interest rate minus the rate of inflation.
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Aman 22 February 2013