The Cost of Living: The Consumer Price Index and

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Week 10

C H A P T E R 22 Unemployment, inflation and long-run growth


The Consumer Price Index Inflation
The Consumer Price Index
and the Cost of Living The Costs of Inflation

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https://www.expatistan.com/cost-of-living

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Consumer Price Index (CPI) - A price index computed each month by the
Bureau of Labor Statistics (U.S.) using a bundle that is meant to represent the
“market basket” purchased monthly by the typical urban consumer.
Producer price indexes (PPIs) - Measures of prices that producers receive
for products at all stages in the production process.
Once called wholesale price indexes, PPIs are calculated separately for
various stages in the production process.

The three main categories are finished goods, intermediate materials, and
crude materials, although there are subcategories within each of these
categories.
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.

The Central Bank of Malaysia (Bank Negara Malaysia) recently reports the CPI
each month - Monthly Statistical Bulletin. It is used to monitor changes in
the cost of living over time.
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The CPI Market Basket –
Central Bank of Malaysia

The CPI market basket shows how a typical consumer divides his or her money
among various goods and services.

The CPI market basket for 2010 (based year) shows that most of a consumer’s
money goes toward “Food & non-alcoholic beverages”, “Housing, water,
electricity, gas & other fuels”, and “Transport”.

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When the CPI rises (Inflation), the typical family has
to spend more dollars to maintain the same standard
of living.
Inflation is always and everywhere a
monetary phenomenon in the sense
that it is and can be produced only by
a more rapid increase in the quantity
of money than in output.
The Counter-Revolution in Monetary Theory (1970)

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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.
• The statistical agency identifies a market basket of goods and
services the typical consumer buys.
• The statistical agency conducts monthly consumer surveys
(e.g. first Monday of each month). to set the weights for the
prices of those goods and services.

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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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.

Price of basket of goods and services


Consumer price index   100
Price of basket in base year

5. 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 Year 2= 100
CPI in Year 1

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Calculating the Consumer Price Index and the Inflation Rate:
Example

Base Year, 2002=100.


Basket of goods in 2002 costs $1,200.
The same basket in 2004 costs $1,236.
CPI = ($1,236/$1,200)  100 = 103.

Prices increased 3% between 2002 (base year, t=0)


and 2004 (current year, t=1).

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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.
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes

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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Problems in Measuring the Cost of Living
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
dollar more valuable.
Consumers need fewer dollars to maintain any given standard of
living.
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.
The Bank Negara Malaysia tries to adjust the price for constant
quality, but such differences are hard to measure.

The CPI overstates inflation by about 1 percentage point per


year – U.S

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The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
The statistical agency calculates other prices indexes:
• The index 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.

The GDP Deflator versus the Consumer Price Index


Economists and policymakers monitor both the GDP deflator and the
consumer 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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The GDP Deflator versus the Consumer Price Index

The GDP deflator reflects the prices of all goods and services
produced domestically, whereas...
…the Consumer Price Index reflects the prices of all goods and
services bought by consumers.

The consumer price index compares the price of a fixed basket of


goods and services to the price of the basket in the base year
(only occasionally does the statistical agency change the
basket)...

…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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Two Measures of Inflation in Australia

20 Percent per Year

15

10

0
1974 1979 1984 1989 1994 1999 2004 2009

GDP def lator CPI


Source: OECD Economic Outlook

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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 dollar figures from different times.

Dollar Figures from Different Times


Do the following to convert dollar values from year T into today’s
dollars:

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Do the following to convert (inflate) Babe Ruth’s wages in 1931
to dollars in 2005:

Indexation
When some dollar amount is automatically corrected for inflation by law
or contract, the amount is said to be indexed for inflation.

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The Costs of Inflation
During inflations, most prices—including input prices like wages—tend to rise
together, and input prices determine both the incomes of workers and the
incomes of owners of capital and land.

*So inflation by itself does not necessarily reduce ones purchasing power.

Inflation May Change the Distribution of Income


One way of thinking about the effects of inflation on the distribution of income is
to distinguish between anticipated and unanticipated inflation.

The effects of anticipated inflation on the distribution of income are likely to be


fairly small, since people and institutions will adjust to the anticipated inflation.

Unanticipated inflation, on the other hand, may have large effects, depending,
among other things, on how much indexing to inflation there is.

Real interest rate - The difference between the interest rate on a loan and the
inflation rate.

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Administrative Costs and Inefficiencies
There may be costs associated even with anticipated inflation, such as the
administrative cost associated with simply keeping up.

Interest rates tend to rise with anticipated inflation. When interest rates are
high, the opportunity costs of holding cash outside of banks is high.

Public Enemy Number One?


Economists have debated the seriousness of the costs of inflation for decades.
No matter what its real economic cost, it makes us uneasy and unhappy.

In 1974, President Ford verbalized some of this discomfort when he said,


“Our inflation, our public enemy number one, will unless whipped destroy our
country, our homes, our liberties, our property, and finally our national pride,
as surely as any well-armed wartime enemy.”

In this belief, our elected leaders have vigorously pursued policies designed to
stop inflation.

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