MEASURING THE
COST OF LIVING
Chapter 6
Copyright © 2014 by Nelson Education Ltd.
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MEASURING THE COST OF LIVING
 The consumer price index is used to monitor
changes in the cost of living over time.
 When the consumer price index rises, the typical
family has to spend more dollars to maintain the
same standard of living.
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MEASURING THE COST OF LIVING
 Economists use the term inflation to describe a
situation in which the economy’s overall price
level is rising.
 The inflation rate is the percentage change in
the price level from the previous period.
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THE CONSUMER PRICE INDEX
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 The consumer price index
(CPI): the overall measure
of the cost of the goods
and services bought by a
typical consumer
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How the Consumer Price Index Is Calculated
Every month, Statistics Canada computes
and reports the CPI.
It uses data on the prices of more than 600
different goods and services.
To see how these statistics are constructed,
a simple economy with two goods, hot
dogs and hamburgers, is used.
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How the Consumer Price Index Is Calculated
Five steps to compute the inflation rate:
1. Determine the basket.
2. Find the prices.
3. Compute the basket’s cost.
4. Choose a base year and compute the
index.
5. Compute the inflation rate.
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TABLE 6.1:
Calculating the CPI and the Inflation Rate
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How the Consumer Price Index Is Calculated
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FYI:
What Is in the CPI Basket?
 Figure 6.1:
The Basket of
Goods and
Services
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Active Learning
Calculate the CPI
CPI basket: {10 kg beef, 20 kg chicken}
The CPI basket cost $120 in 2008, the
base year.
A. Compute the CPI in 2009.
B. What was the CPI inflation rate from
2009-2010?
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price
of
beef
price of
chicken
2008
$4
$4
2009
$5
$5
2010
$9
$6
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Active Learning
Answers
CPI basket: {10 kg beef, 20 kg chicken}
price
of
beef
price of
chicken
2008
$4
$4
2009
$5
$5
2010
$9
$6
The CPI basket cost $120 in 2008, the base
year.
A. Compute the CPI in 2009:
Cost of CPI basket in 2009
= ($5 x 10) + ($5 x 20) = $150
CPI in 2009 = 100 x ($150/$120) = 125
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Active Learning
Answers
CPI basket: {10 KG beef, 20 KG chicken}
price
of
beef
price of
chicken
2008
$4
$4
2009
$5
$5
2010
$9
$6
The CPI basket cost $120 in 2008, the base
year.
B. What was the inflation rate from 2009-2010?
Cost of CPI basket in 2010
= ($9 x 10) + ($6 x 20) = $210
CPI in 2010 = 100 x ($210/$120) = 175
CPI inflation rate = (175 – 125)/125 = 40%
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Problems in Measuring the Cost of Living
 Commodity substitution bias
 Introduction of new goods
 Unmeasured quality change
Taken together, these sources of bias cause the
CPI to overstate the cost of living by 0.6
percentage points a year according to the Bank
of Canada.
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The GDP Deflator versus
the Consumer Price Index
 The GDP deflator reflects the current level of prices
relative to the level of prices in the base year.
 Economists and policy makers monitor both the CPI and
the GDP deflator to gauge how quickly prices are rising.
 Two differences:
 The GDP deflator reflects prices of goods and services
produced domestically.
 The GDP deflator compares the price of currently
produced goods and services with the price of the
same goods and services produced during the base
year.
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FIGURE 6.2:
Two Measures of Inflation
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QuickQuiz
Explain briefly what the consumer price
index is trying to measure and how it is
constructed.
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CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
The purpose of measuring the overall level
of prices in the economy is to permit
comparison between dollar figures from
different points in time.
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Dollar Figures from Different Times
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FYI:
BoC Inflation Calculator
http://www.bankofcanada.ca/rates/related/inflation-calculator/
A basket of goods and services that cost $100 in 1914
would cost how much in 1973? In 1983? In 1993?
In 2003? In 2013?
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Case Study:
Mr. Index Goes to Hollywood
 What is the most
popular movie of all
time?
 Gone with the Wind!
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Indexation
Indexation: the automatic correction of a
dollar amount for the effects of inflation by
law or contract
COLA: A COLA automatically raises the
wage when the CPI raises.
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Real and Nominal Interest Rates
 Interest rates involve
comparing amounts of money
at different points in time.
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alexyndr/Shutterstock
 To fully understand interest
rates, knowing how to correct
for the effects of inflation is
important.
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Real and Nominal Interest Rates
 Suppose that you make a deposit of $1000 in a
bank account that pays interest at a rate of 10
percent per year.
 After one year, that bank account now contains
$1100 (= Principal of $1000 + Interest of $100).
 Are you actually wealthier after one year?
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Real and Nominal Interest Rates
Nominal interest rate: the interest rate that
is usually reported without a correction for
the effects of inflation
Real interest rate: the interest rate that is
corrected for the effects of inflation
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QuickQuiz
Henry Ford paid his workers $5 a day in 1914.
If the U.S. consumer price index was 10 in
1914 and 195 in 2012, how much is the Ford
paycheque worth in 2012?
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Case Study:
Interest Rates in the Canadian Economy
 Figure 6.3: Real and Nominal Interest Rates
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Cost of inflation
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Some extreme examples
 The costs of inflation are readily apparent during extreme episodes of inflation,
known as hyperinflation. The most famous episode of hyperinflation occurred in
Germany in the 1920s when prices increased 100 times from mid-1922 through
mid-1923. By November 1923, the price level was more than one billion times
its level in August 1922.
 Anecdotes of the distortionary effects of the German hyperinflation include
stories that workers were paid two to three times per day, rushing out to spend
their pay before their money became worthless.
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Cost of Unanticipated Inflation
 Redistributions of wealth
 If inflation is higher than anticipated, debtors gain at the expense of creditors.
 Wages can be protected with COLA (cost of living adjustments) clauses.
 Social conflict
 Uncertainty
 Resources are diverted to reducing uncertainty.
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THE END
Chapter 6
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