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## The CPI and the Cost of Living

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**15**The CPI and the Cost of Living CHAPTER In the fall of 1972 President Nixon announced that the rate of increase of inflation was decreasing. This was the first time that a sitting president used the third derivative to advance his case for re-election. Hugo Rossi Professor of Mathematics University of Utah**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 • 1Explain what the Consumer Price Index (CPI) is and how it is calculated. • 2 Explain the limitations of the CPI and describe other measures of the price level. 3 Adjust money values for inflation and calculate real wage rates and real interest rates.**15.1 THE CONSUMER PRICE INDEX**• Consumer Price Index (CPI) - measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. • The Bureau of Labor Statistics (BLS) calculates the CPI every month. • We can use these numbers to compare what a fixed basket of goods costs this month with what it cost in some previous month.**15.1 THE CONSUMER PRICE INDEX**• Reading the CPI Numbers • The CPI =100 for a period called the reference base period. • Currently, the reference base period is 19821984.**15.1 THE CONSUMER PRICE INDEX**• In August 2007, the CPI was 207.9. • The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 107.9% higher in August 2007 than it was on the average during 19821984. • In July 2007 (a month earlier), the CPI was 208.3. • The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.4 of a percentage point in August 2007.**15.1 THE CONSUMER PRICE INDEX**• Constructing the CPI • Three stages: • Selecting the CPI basket • Conducting the monthly price survey • Calculating the CPI**15.1 THE CONSUMER PRICE INDEX**• The CPI Basket • Make the relative importance of the items in the CPI basket the same as in the budget of an average urban household. • The CPI is calculated each month, but the CPI basket is not updated each month. • The current CPI basket in 2007 is based on information obtained from the Consumer Expenditure Survey conducted during 2005.**15.1 THE CONSUMER PRICE INDEX**Figure 15.1 shows the CPI basket. This shopping cart is filled with the items that an average household buys.**15.1 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 exactly the same items.**15.1 THE CONSUMER PRICE INDEX**• Calculating the CPI • The CPI calculation has three steps: • Find the price of the CPI basket at base period prices. • Find the price of the CPI basket at current period prices. • Calculate the CPI for the base period and the current period. Table 15.1 on the next slide shows a simplified CPI calculation in which we assume a base period of 2005.**Price of CPI basket at current period prices**x 100 Price of CPI basket at base period prices $50 $70 x 100 x 100 = 100 = 140 For 2005, the CPI is: $50 $50 For 2008, the CPI is: 15.1 THE CONSUMER PRICE INDEX CPI =**CPI in current year CPI in previous year**x 100 Inflation rate = CPI in previous year 140 120 x 100 = 16.7% Inflation rate = 120 15.1 THE CONSUMER PRICE INDEX • Measuring Inflation • Inflation rate - percent change in the price level from one year to the next.**15.1 THE CONSUMER PRICE INDEX**Figure 15.2 shows the CPI in part (a) and the inflation rate in part (b).**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• 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**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• 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. • A price rise that is a payment for improved quality is not inflation but might get measured as inflation.**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• 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. • 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.**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• 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.**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• Two Consequences of the CPI Bias • Distortion of Private Contracts • Many wage contracts are linked to the CPI. • If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties.**15.2 THE CPI AND OTHER PRICE LEVEL MEASURES**• Two Consequences of the CPI Bias • Increases in Government Outlays and Decreases in Taxes • 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 (est. over $220 billion overpayment thru 1996) • 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**CPI in 2007**Price of stamp in 1907 dollars x CPI in 1907 207.2 = 41 cents = 2 cents x 10 15.3 NOMINAL AND REAL VALUES • Dollars and Cents at Different Dates • To compare dollar amounts at different dates, we need to know the CPI at those dates. • Convert the price of a 2-cent stamp in 1907 into its 2007 equivalent: Price of stamp in 2007 dollars =**15.3 NOMINAL AND REAL VALUES**• Nominal and Real Values in Macroeconomics • Macroeconomics makes a big issue of the distinction between nominal values and real values: • Nominal GDP and real GDP • Nominal wage rate and real wage rate • Nominal interest rate and real interest rate • We studied the distinction between and calculation of nominal and real GDP in Chapter 21. Here, we’ll look at the other two.**15.3 NOMINAL AND REAL VALUES**• Nominal and Real Wage Rates • Nominal wage rate the average hourly wage rate measured in current dollars. • Real wage rate the average hourly wage rate measured in the dollars of a given reference base year (or purchasing power of the wage).**Nominal wage rate in 2006**x 100 Real wage rate in 2006 = CPI in 2006 $16.73 x 100 = $8.23 Real wage rate in 2006 = 201.6 15.3 NOMINAL AND REAL VALUES To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is, The $8.23 amount is in 19821984 dollars.**15.3 NOMINAL AND REAL VALUES**Figure 15.4 shows nominal and real wage rates: 1982–2006. The nominal wage rate has increased every year since 1982. The real wage rate decreased slightly from 1982 through the mid-1990s, after which increased slightly.**15.3 NOMINAL AND REAL VALUES**• Nominal and Real Interest Rates • Nominal interest rate is the percentage return on a loan expressed in dollars. • Real interest rate is 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.**15.3 NOMINAL AND REAL VALUES**Figure 15.5 shows real and nominal interest rates: 1967–2007. During the 1970s, the real interest rate became negative. The nominal interest rate increased during the high-inflation 1980s.