© 2013 Pearson
The CPI and the
Cost of Living
23
CHECKPOINTS
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Checkpoint 23.1
Checkpoint 23.2
Checkpoint 23.3
Problem 1
Problem 1
Problem 1
Problem 2
Problem 2
Problem 2
Problem 3
Problem 3
Problem 3
In the news
In the news
In the news
© 2013 Pearson
CHECKPOINT 23.1
Practice Problem 1
A Consumer Expenditure Survey in Sparta shows that
people buy only juice and cloth.
In 2010, the year of the Consumer Expenditure Survey and
also the reference base year, the average household spent
$40 on juice and $25 on cloth.
Table 1 sets out the
prices of juice and cloth.
Calculate the CPI market basket and the percentage of
household budget spent on juice in the base year.
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CHECKPOINT 23.1
Solution
The CPI market basket is the
quantities bought during the
reference base year, 2010.
Households spent $40 on juice and at $4 a bottle, so the
quantity of juice bought was 10 bottles.
Households spent $25 on cloth at $5 a yard, so the quantity
of cloth bought was 5 yards.
The CPI market basket is 10 bottles of juice and 5 yards of
cloth.
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CHECKPOINT 23.1
In the reference base year, the average household spent
$40 on juice and $25 on cloth, so the household budget
was $65.
Expenditure on juice was 61.5 percent of the household
budget: ($40 ÷ $65) x 100 = 61.5 percent.
© 2013 Pearson
CHECKPOINT 23.1
Practice Problem 2
A consumer Expenditure Survey in Sparta shows that
people buy only juice and cloth.
In 2010, the year of the Consumer Expenditure Survey and
also the reference base year, the average household spent
$40 on juice and $25 on cloth.
Table 1 sets out the prices of
juice and cloth.
Calculate the CPI in 2012 and inflation between 2010 and
2012.
© 2013 Pearson
CHECKPOINT 23.1
Solution
To calculate the CPI in
2012, find the cost of the
CPI basket in 2010 and 2012.
In 2010, the CPI basket costs $65
($40 for juice + $25 for cloth).
In 2012, the CPI basket costs $70
(10 bottles of juice at $4 a bottle + 5 yards at $6 a yard).
The CPI in 2012 is ($70 ÷ $65) x 100 = 107.7.
The inflation between 2010 and 2012 is
[(107.7 – 100) ÷ 100] x 100, which is 7.7 percent.
© 2013 Pearson
CHECKPOINT 23.1
Practice Problem 3
The table shows the CPI in
Russia.
Calculate Russia’s inflation
rate in 2006 and 2007.
Did the price level rise or fall in
2007?
Did the inflation rate increase
or decrease in 2007?
© 2013 Pearson
CHECKPOINT 23.1
Solution
The inflation rate in 2006 is
[(219 – 200) ÷ 200] x 100 = 9.5
percent.
The inflation rate in 2007 is
[(237 – 219) ÷ 219] x 100 = 8.2
percent.
In 2007, the price level
increased, but the inflation rate
decreased.
© 2013 Pearson
CHECKPOINT 23.1
In the news
Consumer price index rises 0.2% in May
The CPI in May 2011was 226, 0.2% higher than the April CPI. That’s
down from April’s increase of 0.4%. Food prices rose 0.4%, but energy
prices fell 1%.
Source: USA Today, June 15, 2011
Use the information in the news clip to distinguish between the price
level and the inflation rate.
Explain why the reason suggested for the fall in the CPI can’t be
entirely correct.
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CHECKPOINT 23.1
Solution
The CPI is the price level. The percentage change in the
CPI is the inflation rate.
Food is 14.8 percent of the CPI basket.
Energy is included in transportation and housing.
For the CPI to have risen by 0.2 percent when energy
prices fell by 1 percent, other prices must have risen by
more than 0.2 percent.
© 2013 Pearson
CHECKPOINT 23.2
Practice Problem 1
The Statistics Bureau decides
to check the substitution bias
in the CPI and it conducts a
Consumer Expenditure Survey
in both 2010 and 2011.
The table shows the results of
the survey: the items that
consumers buy and their prices.
Calculate the CPI in 2011 using
the 2010 CPI market basket.
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The Statistics Bureau fixes
the reference base year as
2010.
CHECKPOINT 23.2
Solution
The table shows the calculation
of the CPI in 2011 using the
2010 basket.
The cost of the 2010 basket at
2011 prices is $60.
The cost of the 2010 basket at
2011 prices is $90.
So the CPI in 2011 using the
2010 basket is ($90 ÷ $60) x
100, which is 150.
© 2013 Pearson
CHECKPOINT 23.2
Practice Problem 2
The Statistics Bureau decides
to check the substitution bias in
the CPI. It conducts a Consumer
Expenditure Survey in both 2010
and 2011.
The table shows the results of
the survey: the items that
consumers buy and their prices.
Calculate the CPI in 2010 using
the 2011 CPI market basket.
© 2013 Pearson
The Statistics Bureau fixes
the reference base year as
2008.
CHECKPOINT 23.2
Solution
The table shows the
calculation of the CPI in 2011
using the 2011 basket.
The cost of the 2011 basket at
2010 prices is $65.
The cost of the 2011 basket at
2011 prices is $85.
So the CPI in 2011 using the
2011 basket is ($85 ÷ $65) x
100, which is 131.
© 2013 Pearson
CHECKPOINT 23.2
Practice Problem 3
The Statistics Bureau decides
to check the substitution bias in
the CPI. It conducts a
Consumer Expenditure Survey
in both 2010 and 2011.
The table shows the results:
the items that consumers buy
and their prices.
Is there any substitution bias in
the CPI that uses the 2010
basket? Explain.
© 2013 Pearson
The Statistics Bureau fixes
the reference base year as
2008.
CHECKPOINT 23.2
Solution
There is some substitution bias in the CPI that uses the
2010 basket.
The price of broccoli remains constant, whereas the price
of carrots rises by 100 percent.
So consumers cut the quantity of carrots consumed and
increase the quantity of broccoli consumed.
They end up spending $85 on vegetables, but they would
have spent $90 if they had not substituted the now
relatively less costly broccoli.
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CHECKPOINT 23.2
The cost of vegetables does not rise by 50 percent as
shown by the CPI.
Instead, because of substitution, the cost of vegetables
increases by only 42 percent ($85 is 42 percent greater
than $60).
When we calculate the increase in the price of
vegetables using the 2009 CPI market basket, the
increase is only 31 percent ($85 compared with $65).
So the CPI is biased upward because it ignores the
substitutions that people make in response to changes
in the price of one item relative to the price of another.
© 2013 Pearson
CHECKPOINT 23.2
In the news
News releases
In 2011, the CPI increased by 1.4 percent, the GDP price
index increased by 1.2 percent, and the PCE price index
increased by 1.8 percent.
Source: Bureau of Economic Analysis, August 29, 2011
Do these three measures of the price level give different
inflation rates?
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CHECKPOINT 23.2
Solution
These three measures of the price level are based on the
prices of different baskets of goods and services.
The GDP price index is the broadest measure and its
basket contains all the goods and services that are counted
in GDP—U.S.-produced goods and services that
households, firms, governments, and foreigners buy in the
current year.
The basket of the PCE price index contains the goods and
services in GDP that households buy in the current year.
The CPI basket contains only the goods and services that
urban consumers buy in the base year.
© 2013 Pearson
CHECKPOINT 23.3
Practice Problem 1
The table shows the gasoline
price and the CPI in 4 years.
The reference base period is
1982–1984.
Calculate the real price of
gasoline in each year in
1982–1984 cents.
In which year was the real
price highest and in which year
was it lowest?
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CHECKPOINT 23.3
Solution
To calculate the real price of
gasoline in 1982–1984 cents,
divide by the CPI and multiply
the nominal price by 100.
The table shows the
calculations.
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CHECKPOINT 23.3
The real price of gasoline
was highest in 1981, when it
was 152 cents (1982–1984
cents) per gallon.
The real price of gasoline
was lowest in 2001, when it
was 83 cents (1982–1984
cents) per gallon.
© 2013 Pearson
CHECKPOINT 23.3
Practice Problem 2
Ford says it cut its labor costs by 35 percent between 2006
and 2011.
Ford’s wage rate, including benefits, was $80 an hour in
2006 and $58 an hour in 2011.
The CPI was 202 in 2006 and 218 in 2011.
Did the real wage rate fall by more or less than 35 percent?
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CHECKPOINT 23.3
Solution
The real wage rate in 2006, expressed in dollars of the
reference base year, was ($80 ÷ 202) X 100 = $39.60 an
hour.
The real wage rate in 2011, expressed in dollars of the
reference base year equals($58 ÷ 218) X 100 = $26.61
an hour.
The real wage rate of Ford workers fell by 32.8 percent.
© 2013 Pearson
CHECKPOINT 23.3
Practice Problem 3
Sally worked hard all year so that she could go to school
full time the following year.
She put her savings into a mutual fund that paid a
nominal interest rate of 7 percent a year.
The CPI was 165 at the beginning of the year and 177 at
the end of the year.
What was the real interest rate that Sally earned?
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CHECKPOINT 23.3
Solution
The inflation rate during the year that Sally worked was
equal to (177 – 165) ÷ 165) x 100 = 7.3 percent.
Her savings in the mutual fund for the full year her earned a
real interest rate equal to the nominal interest rate minus the
inflation rate, which is 7.0 – 7.3 = – 0.3 percent.
Sally’s real interest rate was negative.
(If Sally had just kept her savings in cash, her nominal
interest rate would have been zero, and her real interest rate
would have been –7.3 percent. She would have been worse
off.)
© 2013 Pearson
CHECKPOINT 23.3
In the news
Inflation can act as a safety valve
Workers will more readily accept a real wage cut that arises
from an increase in the consumer prices than a cut in their
nominal wage rate.
Source: FT.com, May 28. 2009
Explain why inflation influences a worker’s real wage rate.
Why might this observation be true?
© 2013 Pearson
CHECKPOINT 23.2
Solution
The real wage rate in 2011 equals
(Nominal wage rate ÷ CPI in 2011) x 100.
Two reasons why a real wage cut from inflation is more
acceptable are: A rising CPI gradually lowers the real
wage rate, while a cut in the nominal wage rate suddenly
lowers the real wage rate.
Inflation gradually lowers everyone’s real wage rate over
the year, while a cut in the nominal wage rate lowers only
that worker’s real wage rate.
© 2013 Pearson