measuring the cost of living Consumer Price Index How the CPI Is Calculated Problems with the CPI Contrasting the CPI and GDP Deflator Correcting Variables for Inflation:

1. Measuring the
Cost of Living
Prepared By:
Prof. Nishant Agrawal

2. In this chapter,In this chapter,
look for the answers to these questions:look for the answers to these questions:
 What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
 What are the problems with the CPI? How serious are they?
 How does the CPI differ from the GDP deflator?
 How can we use the CPI to compare dollar amounts from
different years? Why would we want to do this, anyway?
 How can we correct interest rates for inflation?
2

3. Consumer Price Index
 It is measure of the overall cost of goods and service bought by
a typical consumer.
 It is used to monitor changes in the cost of living over time.
 When CPI rises typical family has to spend more dollars to
maintain the same standard of living.

4. How the CPI Is Calculated
CPI measures the typical consumer’s cost of living
1. Fix the “basket.”
It is typical consumer’s “shopping basket.”
2. Find the prices of each good in each year.
It is the prices of all the goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.

5. How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
5. Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
100 x
cost of basket in current year
cost of basket in base year
CPI this year – CPI last year
CPI last year
Inflation
rate
x 100%=

6. EXAMPLE basket: {4 pizzas, 10 burger}
$12 x 4 + $3 x 10 = $78
$11 x 4 + $2.5 x 10 = $69
$10 x 4 + $2 x 10 = $60
cost of basket
$3.00
$2.50
$2.00
price of
burger
$122009
$112008
$102007
price of
pizza
year
Compute CPI in each year
2007: 100 x ($60/$60) = 100
2008: 100 x ($69/$60) = 115
2009: 100 x ($78/$60) = 130
Inflation rate:
15%
115 – 100
100
x 100%=
13%
130 – 115
115
x 100%=
using 2007 base year:
Inflation Rate is percentage change in the price level from Previous period.

7. Practice Problem
 Suppose that the Indian Spend all of their income on Potatoes,
Onions and Tomatoes.
 In 2006 they buy 50 kg of Potatoes for $150 ,35 kg of Onions
for $140 and 100 kg of Tomatoes for $500.
 In 2007 they buy 35 kg of Potatoes for $140 , 50 kg of Onions
for $200 and 100 kg of Tomatoes for $600.
1.Calculate prices of each item in each year.
2.Using 2006 base year, Calculate CPI for each year.
3.What is the inflation rate for 2007?

8. Price of
potatoes
Price of
onions
Price of
tomatoes
2006 $150 $140 $500
2007 $140 $200 $600
Ans 1

9. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11
CalculatCalculate the CPIe the CPI
9
CPI basket:
{10 pani puri,
20 wada pav}
The CPI basket cost $120
in 2004, the base year.
A. Compute the CPI in 2005.
B. What was the CPI inflation rate from 2005-2006?
price of
pani
puri
price of
wada
pav
2004 $4 $4
2005 $5 $5
2006 $9 $6

10. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11
AnswersAnswers
10
A. Compute the CPI in 2005:
Cost of CPI basket in 2005
= ($5 x 10) + ($5 x 20) = $150
CPI in 2005 = 100 x ($150/$120) = 125
CPI basket:
{10 pani puri,
20 wada pav}
The CPI basket cost $120
in 2004, the base year.
price
of pani
puri
price of
wada
pav
2004 $4 $4
2005 $5 $5
2006 $9 $6

11. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11
AnswersAnswers
11
price
of pani
puri
price of
wada
pav
2004 $4 $4
2005 $5 $5
2006 $9 $6
CPI basket:
{10 pani puri,
20 wada pav}
The CPI basket cost $120
in 2004, the base year.
B. What was the inflation rate from 2005-2006?
Cost of CPI basket in 2006
= ($9 x 10) + ($6 x 20) = $210
CPI in 2006 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%

12. What’s in the CPI’s Basket?
43%
17%
15%
6%
6%
6%
4% 3% Housing
Transportation
Food & Beverages
Medical care
Recreation
Education and
communication
Apparel
Other

13. CPI basket:
{10 pizza, 20 Dosa}
2004-5:
Households
bought CPI basket.
2006: Households bought {5 pizza, 25 Dosa}.
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 22
Substitution biasSubstitution bias
13
Pizza Dosa
cost of CPI
basket
2004 $4 $4 $120
2005 $5 $5 $150
2006 $9 $6 $210
A. Compute cost of the 2006 household basket.
B. Compute % increase in cost of household basket
over 2005-6 compare to CPI inflation rate.

14. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 22
AnswersAnswers
14
A. Compute cost of the 2006 household basket.
($9 x 5) + ($6 x 25) = $195
CPI basket:
{10 pizza, 20 Dosa}
Household
basket in 2006:
{5 pizza, 25 Dosa}.
Pizza Dosa
cost of CPI
basket
2004 $4 $4 $120
2005 $5 $5 $150
2006 $9 $6 $210

15. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 22
AnswersAnswers
15
B. Compute % increase in cost of household basket
over 2005-6, compare to CPI inflation rate.
Rate of increase: ($195 – $150)/$150 = 30%
CPI basket:
{10 pizza, 20 Dosa}
Household basket in
2006:
{5 pizza, 25 Dosa}.
Pizza Dosa
cost of CPI
basket
2004 $4 $4 $120
2005 $5 $5 $150
2006 $9 $6 $210

16. Problems with the CPI:
Substitution Bias
 Over time, some prices rise faster than others.
 Consumers substitute toward goods that become relatively
cheaper.
 The CPI misses this substitution because it uses a fixed basket
of goods.
 Thus, the CPI overstates increases in the cost of living.

17. Problems with the CPI:
Introduction of New Goods
 The introduction of new goods increases variety, allows
consumers to find products that more closely meet their needs.
 In effect, dollars become more valuable.
 The CPI misses this effect because it uses a fixed basket of
goods.
 Thus, the CPI overstates increases in the cost of living.

18. Problems with the CPI:
Unmeasured Quality Change
 Improvements in the quality of goods in the basket
increase the value of each dollar.
 Thus, the CPI increases in the cost of living.

19. Two Measures of Inflation, 1950-2007
-5
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Percent
per Year
CPI GDP deflator
Both are used to determine price inflation

20. Imported consumer goods:
 included in CPI
 excluded from GDP deflator
Imported consumer goods:
 included in CPI
 excluded from GDP deflator
The basket:
 CPI
 GDP deflator
This matters if different prices are
changing by different amounts.
The basket:
 CPI
 GDP deflator
This matters if different prices are
changing by different amounts.
Capital goods:
 excluded from CPI
 included in GDP deflator
(if produced domestically)
Capital goods:
 excluded from CPI
 included in GDP deflator
(if produced domestically)
Contrasting the CPI and GDP Deflator

21. CPI Vs GDP Deflector
CPI
 Uses fixed basket
 Reflect prices of representative
basket of G&S bought by
consumer
GDP Deflector
 Uses basket of currently
produced goods & services
 Reflect prices of all G&S
produced domestically

22. In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 33
CPI vs. GDP deflatorCPI vs. GDP deflator
22

23. A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 33
AnswersAnswers
23

24. Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
 Salary of Dilip Kumar was $80,000 in 1931 high or low compare
to the salary of today’s actor? Shahrukh salary is $20,00,000
 To Ans this Que, we need to know level of prices in 1931 and
level of price today.
 CPI of 15.2 for 1931 &195 for 2015
Amount
in today’s
dollars
Amount
in year T
dollars
Price level today
Price level in year T
= x

25. Continue….
= $80,000
 Salary in 2015 dollars = $10,26,316
Salary in
2015
dollars
Salary in
1931
dollars
= x
Price level 2015
Price level in 1931
x
195
15.2

26. Example
 Example: the minimum wage
 $1.15 in Dec 1964
 $5.85 in Dec 2007
 min wage have more purchasing power in
Dec 1964 or Dec 2007?
 CPI = 31.3 in year T, CPI = 211.7 today

27.  year T = 1964, “today” = 2007
 Min wage = $1.15 in year 1964
 CPI = 31.3 in year 1964, CPI = 211.7 today
Continue…
Amount
in today’s
dollars
Amount
in year T
dollars
Price level today
Price level in year T
= x
$7.78 $1.15 211.7
31.3
= x
Interpreting the result: The $1.15 minimum wage in December 1964 could
have purchased $7.78 worth of goods and services if prices in 1964 equaled
their December 2007 level.

28. Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
 Researchers, business analysts and policymakers often
use this technique to convert a time series of current-
dollar (nominal) figures into constant-dollar (real) figures.
 They can then see how a variable has changed over
time after correcting for inflation.
 Example: the minimum wage, from Jan 1950 to Dec
2007…

29. The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1950-2007
$perhour
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
current dollars
2007 dollars

30. Annual tuition and fees, average of all public four-year
colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
After adjusting for inflation, did students pay more for
college in 1986 or in 2006? Convert the 1986 figure to
2006 dollars and compare.
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 44
Converting to “today’s dollars”Converting to “today’s dollars”
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31. A C T I V E L E A R N I N GA C T I V E L E A R N I N G 44
AnswersAnswers
31
Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 1986 than in 2006!
Annual tuition and fees, average of all public four-
year colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)

32. Correcting Variables for Inflation:
Indexation
For example, the increase in the CPI automatically determines
 the COLA in many multi-year labor contracts
 the adjustments in Social Security payments and federal
income tax brackets
A dollar amount isA dollar amount is indexedindexed for inflationfor inflation
if it is automatically corrected for inflationif it is automatically corrected for inflation
by law or in a contract.by law or in a contract.

33. Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The Nominal Interest rate:
 the interest rate not corrected for inflation
 the rate of growth in the dollar value of a deposit OR how fast
number of dollars in your bank account rises over time.
The Real Interest rate:
 How fast the purchasing power of bank account rises over time.
 Difference between nominal interest rate and interest rate
Real interest rate
= (nominal interest rate) – (inflation rate)

34. Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
Example:
 Deposit $1,000 for one year.
 Nominal interest rate is 9%.
 During that year, inflation is 3.5%.
 Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit has grown 5.5%.

35. Real and Nominal Interest Rates in the U.S.,
1950-2007
-10
-5
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
InterestRates
(percentperyear)
Nominal interest rate Real interest rate

36. Practice Problem
Year Price of Cotton
(in rupees)
Quantity of
Cotton
Price of Cheese (in
rupees)
Quantity of
Cheese
2010 1 100 2 50
2011 1 200 2 100
2012 2 200 4 100
a) Compute nominal GDP, real GDP and the GDP deflator for each year, using
2010 as the base year.
b) Compute the percentage change in nominal GDP, real GDP and GDP
deflator in 2011 and 2012 from the preceding year. For each year, identify the
variable that does not change. Justify the result.
c) Did economic well-being rise more in 2011 or 2012 ? Explain.

37. Practice Problem
37
Use the above data to solve these problems:
A. Compute nominal GDP , Compute real GDP ,
Compute the GDP deflator for each year.
2012 (base yr) 2013 2014
P Q P Q P Q
Chocolate $50 1200 $92 1500 $99 1777
Ice Cream $99 203 $111 266 $122 289

38.  The Consumer Price Index is a measure of the cost of living.
 Difference between CPI and GDP Deflector
 Comparing Dollar Figures from Different Times
 Concept of Nominal Interest and Real Interest rate.
38

39. End of Session
/nishant4uagrawal /agrawalnishant1nishant4uagr@gmail.com