The CPI and the Cost of Living

2. 22 The CPI and the Cost of Living CHAPTER

3. 1 2 3 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Explain what the Consumer Price Index (CPI) is and how it is calculated. Explain the limitations of the CPI as a measure of the cost of living. • Adjust money values for inflation and calculate real wage rates and real interest rates.

4. What is Inflation? An increase in the general (average) price level of goods and services in the economy

5. What is Deflation? A decrease in the general (average) price level of goods and services in the economy

6. THE CONSUMER PRICE INDEX • Consumer Price Index (CPI) • A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. • CPI is the most widelyreported measure of Inflation.

7. THE CONSUMER PRICE INDEX • The Monthly Price Survey • Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. • Because the CPI measures price changes, it is important that the prices recorded refer to similar market basket of goods.

8. THE CONSUMER PRICE INDEX • Average prices of a market basket of goods is calculated in 1984. • Average prices of market basket of goods is calculated in 2005. • The base year in this example is 1985. • The current year in this example is 2005. • The CPI is defined to equal 100 for a period called the reference base period. • The CPI calculated for the current year, May 2005, is 194.4. • Now comparing these two market basket of goods, we can conclude that the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 1985.

9. THE CONSUMER PRICE INDEX • So if you were making $30,000 in 1985, how much money would you need so that you would have the same standard of living in 2005? • You would need $58,200 in 2005. • A base year is chosen as a reference point to compare it with current year. • Base year is chosen by the researcher • Choosing the base period (1985) CPI =100 • Current period (2005) CPI = 194 • The base period is always 100. (CPI in 1985) • CPI (current year) greater then 100 (base year) inflation • CPI (current year) less then 100 (base year) deflation

10. THE CONSUMER PRICE INDEX • Constructing the CPI • Three stages: • Selecting the CPI basket • Conducting the monthly price survey • Calculating the CPI

11. THE CONSUMER PRICE INDEX Figure shows the CPI basket. This shopping cart is filled with the items that an average household buys.

12. THE CONSUMER PRICE INDEX • Calculating the CPI • The CPI calculation has three steps: • Find the cost of the CPI basket at base period prices. • Find the cost of the CPI basket at current period prices. • Calculate the CPI for the base period and the current period.

13. THE CONSUMER PRICE INDEX Table shows the consumer price index: a simplified CPI calculation.

14. Cost of CPI basket at current period prices x 100 Cost of CPI basket at base period prices $50 $70 x 100 x 100 = 100 = 140 For 2000, the CPI is: $50 $50 For 2003, the CPI is: THE CONSUMER PRICE INDEX CPI =

15. CPI in current year  CPI in previous (base) year x 100 Inflation rate = CPI in previous (base) year 140  100 x 100 = 40 percent Inflation rate = 100 THE CONSUMER PRICE INDEX • Measuring Inflation • Inflation rate • The percentage change in the price level from one year to the next.

16. THE CONSUMER PRICE INDEX Figure shows the CPI in part (a) and the inflation rate in part (b).

17. THE CONSUMER PRICE INDEX In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

18. THE CONSUMER PRICE INDEX In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.

19. THE CPI AND THE COST OF LIVING • Cost of living index • A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. • The CPI does not measure the cost of living because • It does not measure all the components of the cost of living • Some components are not measured exactly • So the CPI is possibly a biased measure.

20. THE CPI AND THE COST OF LIVING • Sources of Bias in the CPI • The potential sources of bias in the CPI are • New goods bias • Quality change bias • Commodity substitution bias • Outlet substitution bias

21. THE CPI AND THE COST OF LIVING • New Goods Bias • New goods do a better job than the old goods that they replace, but cost more. • The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. • Quality Change Bias • Better cars and televisions cost more than the versions they replace. upward bias • A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

22. THE CPI AND THE COST OF LIVING • Commodity Substitution Bias • If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. • The CPI basket doesn’t change to allow for the effects of substitution between goods. upward bias • Outlet Substitution Bias • If prices rise more rapidly, people use discount stores more frequently. • The CPI basket doesn’t change to allow for the effects of outlet substitution. upward bias

23. THE CPI AND THE COST OF LIVING • The Magnitude of the Bias • The Boskin Commission estimated the bias to be 1.1 percentage points per year. • If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. • To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years. • When the BLS revises the CPI basket, the reference base period does not change.

24. 22.2 THE CPI AND THE COST OF LIVING • Two Consequences of the CPI Bias • Two main consequences of the bias in the CPI are • Distortion of private agreements • Increases in government outlays • Distortion of Private Agreements • Many private agreements, such as wage contracts, are linked to the CPI. • If the CPI is biased, these agreements might deliver an outcome different from that intended by the parties.

25. 22.2 THE CPI AND THE COST OF LIVING • Increases in Government Outlays • Close to a third of federal government outlays are linked directly to the CPI. • The CPI is used to adjust • 48 million Social Security benefit payments • 22 million food stamp payments • 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses • the budget for 27 million school lunches

26. Why calculate CPI? • Retirement planning/pension plans • Standard on living • Purchasing power of your income • Inflation rate • Pay negotiation/ private agreements • Union contracts • Government contracts • 48 million Social Security benefit payments • 22 million food stamp payments • 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses • the budget for 27 million school lunches

27. Nominal wage rate in 2002 x 100 Real wage rate in 2002 = CPI in 2002 $30,000 x 100 = $27,272 Real wage rate in June 2002 = 110 Real wages and Nominal wages To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is, Loss of purchasing power of $2,728 (Pay cut)

28. 22.3 NOMINAL AND REAL VALUES • Nominal and Real Interest Rates • Nominal interest rate • The percentage return on a loan expressed in dollars. • Real interest rate • The percentage return on a loan, calculated by purchasing power—the nominal interest rate adjusted for the effects of inflation. • Real interest rate = Nominal interest rate – Inflation rate

29. The CPI in YOUR Life Think about your student loan—or if you don’t have one, think about Gus’s $80,000 loan. Suppose that the CPI rises by 3 percent a year, each year from now through 2025. How much will a $100 repayment cost you, in 2005 dollars, when you start to pay off your loan in 2015? How much will a $100 repayment cost you, in 2005 dollars, when you make your final payment in 2025? What is the real interest rate that you will have paid? Would you be better off or worse off if the CPI began to rise at 5 percent a year?