2. CONSUMER PRICE INDEX (CPI)
Measuring the Price Level
The CPI for any period measures the
cost in that period of a standard set, or
basket, of goods and services relative to
the cost of the same basket of goods
and services in a fixed year, called the
base year.

3. Example:
Suppose that a family’s budget
consists of spending on just three
items: rent on a two-bedroom
apartment, hamburgers, and movie
tickets.
By how much does this family’s
cost of living increase between 2000
and 2008?

4. This table shows the costs of this family’s
spending in both 2000 and 2008
Cost Cost
Item (in 2008) (in 2000)
Rent, two-bedroom $630 $500
apartment
Hamburgers 150 120
(60) ($2.50 each) ($2.00 each)
Movie Tickets 70 60
(10) ($7.00 each) ($6.00 each)
Total Expenditure $850 $680

6. Interpretation
Therefore, the cost of living in 2008 is 25% higher
than in 2000 (The CPI of the base year is always
equal to 1 since in that year the numerator and the
denominator of the CPI formula are the same. The
CPI for a given period (such as a month or a year)
measures the cost of living in that period relative to
what is was in the base year.
The BSI multiplies the CPI by 100 to get rid of the
decimal point, so the CPI in 2008 is 125 and the
base year CPI is 100.

7. Exercise 1
Suppose that in addition to the three goods
and services the typical family consumed in
2000 they also bought four sweaters for $30
each. In the year 2008 the sweaters cost
$50 each. With this additional item, what
was the change in the family’s cost of living
between 2000 and 2008?

8. Price Index
The CPI is not itself the price of a specific good or
service. It has no units of measurement since the
dollars in both the numerator and the denominator
cancel out.
The CPI is an index. The value of an index in a
particular year has meaning only in comparison
with the value of that index in another year.
The price index measures the average price of a
class of goods or services relative to the price of the
same goods or services in a base year.

9. Price Index
The CPI is an especially well-known index, and is
used by economists to assess economic trends.
There is also the producer price index (PPI) which
is of interest because manufacturers tend to pass
on increases in the prices of inputs to their
customers, so economists use indexes of input
prices to try to forecast changes in the prices of
manufactured goods.
Other indexes are used to study the rate of price
change in energy, food, health care, and other
major sectors.

11. Calculating Inflation Rates
CPI values for the years 1929-1933 and
2003-2007 are shown in the table below.
Find the rates of inflation between the years
(1929-1933 and 2003-2007).
How did the inflation rates in the 1930s differ
from those in the early 2000s?
Year CPI Year CPI
1929 171 2003 184
1930 167 2004 188.9
1931 152 2005 195.3
1932 137 2006 201.6
1933 130 2007 207.3

12. Negative Inflation Rates
The results for the calculations for the
inflation rate from 1929 to 1933 show
examples of negative inflation rates.
This situation where the prices of most goods
and services are falling over time so that
inflation is negative is called deflation.

13. Adjusting for Inflation
The CPI is an extremely useful tool, as it
allows us to measure changes in the cost of
living and it can be used to adjust economic
data to eliminate the effects of inflation.
When the CPI is used to convert quantities
measured at current dollar values into real
terms, it is a process called deflating.
When it is used to convert real quantities into
current-dollar terms, it is a procedure called
indexing.

15. Example:
Suppose that the typical family in a certain
metropolitan area had a total income of
$20,000 in year 2000 and $22,000 in year
2008. Was this family economically better off
in the year 2008 than in the year 2000?
(Assume the prices of the goods and services
rose by 25% percent over that period)

16. Indexing to Maintain Buying Power
The CPI can also be used to convert real
quantities to nominal quantities.
If Congress wants to maintain the buying power
of the Social Security recipients to remain
constant over time, so that their standard of
living is unaffected by inflation.
The nominal, or dollar benefit depends on how
much inflation has taken place between 2000
and 2008. Suppose the CPI has risen 20% over
this period, and the SS benefit is of $1000.
So in order for the SS recipients to “keep up”
with inflation, their benefit must be $1000 +
.20($1000) = $1200 (20% higher than it was in
2000.

17. Indexing to Maintain Buying Power
This practice of increasing a nominal quantity
according to changes in a price index to prevent
inflation from eroding purchasing power is
called indexing.

18. Indexing a Labor Contract
A labor contract provides for a first-year wage
of $12.00 per hour and specifies that the real
wage will rise by 2 percent in the second year of
the contract and by another 2 percent in the
third year. The CPI is 1.00 in the first year,
1.05 in the second year, and 1.10 in the third
year.
What are the dollar wages that must be paid in
the second and third years of the contract?

19. Indexing a Labor Contract: Solution
Because the CPI is 1.00 in the first year, both
the nominal and real wage are $12.00. We will
let W2 and W3 be the nominal wages in the
second and third year.
1. Deflating by the CPI in the second year, the real
wage is W2/1.05. Since the contract says that the
second year real wage must be 2% higher than the
real wage in the first year, so
W2/1.05 = $12.00(1.02)
W2/1.05 = $12.24
W2 = $12.85
Nominal wage required by the contract for the second
year must be $12.85
2. What must the nominal wage be in the third
year?

20. Recap: Methods to Adjust for Inflation
1. Deflating: To correct a nominal quantity,
such as a family’s dollar income, for changes
in the price level, divide it by a price index,
such as the CPI. This process, called
deflating the nominal quantity, expresses
the nominal quantity in terms of real
purchasing power. If nominal quantities
from two different years are deflated by a
price index with the same base year, the
purchasing power of the two deflated
quantities can be compared.

21. Recap: Methods to Adjust for Inflation
2. Indexing: To insure that a nominal
payment, such as a Social Security benefit,
represents a constant level of real
purchasing power, increase the nominal
quantity each year by a percentage equal to
the rate of inflation for that year. This
process is called indexing.