Chapter 11 Measuring the Cost of Living The Consumer Price Index How CPI is Calculated consumer price index CPI measure of overall cost of goods services bought by a typical consumer fix the basket Determine which prices are most important to the typical consumer find the prices Find the prices of each of the goods and services in the basket at each point in time 1 2 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 4 choose a base year and compute the index designate one year as the base year the benchmark against which other years are compared 5 compute the inflation rate Use the consumer price index to calculate the inflation rate the percentage change in the price index from the preceding period producer price index measure of the cost of a basket of goods services bought by firms Problems in Measuring the Cost of Living substitution bias prices do not change proportionally each year so consumers buy less expensive items introduction of new goods As new goods are introduced consumers have more choices and each dollar is worth more Yet because the consumer price index is based on a fixed basket of goods and services it does not reflect the increase in the value of the dollar that arises from the introduction of new goods unmeasured quality change If the quality of a good deteriorates from one year to the next while its price remains the same the value of a dollar falls because you are getting a lesser good for the same amount of money The GDP Deflator vs CPI 1st difference 2nd difference o GDP deflator reflects prices of all goods services produced domestically o CPI reflects the prices of all goods services bought by consumers o CPI compares the price of a fixed basket of goods services to the price of the basket in the base year o GDP deflator compares the price of currently produced goods services to the price of the same goods and services in the base year Correcting Economic Variables for the Effects of Inflation Dollar Figures from Different Times indexed automatic correction by law or contract of a dollar amount for the effects of inflation nominal interest rate interest rate as usually reported without a correction for the effects of inflation real interest rate interest rate corrected for the effects of inflation o real interest rate nominal inflation rate inflation rate
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