Chapter 11
Measuring the Cost of Living
Outline
Construction of CPI
Calculation of CPI and the Inflation Rate
Problems in measuring CPI
GDP Deflator versus CPI
Correcting economic variables for the
effects of inflation
Indexation
Real and Nominal interest rates
CPI
 The Consumer Price Index (CPI) is a measure
of the overall cost of the goods and services
bought by a typical consumer.
 CPI measures changes in the cost of living
over time.
 CPI estimates by how much incomes must rise
to maintain a constant standard of living.
 CPI reflects the purchasing power of the
currency
 It reports the movement of prices with an index
number.
Calculating CPI: Various Steps
1. Fix the Basket: Identify the basket of goods
consumed by a typical consumer
2. Find the Prices: Find the prices of each of the
goods and services in the basket for each
point in time
3. Compute the Basket’s Cost: Calculate the cost
of the basket of goods and services at different
times
4. Choose a base year and compute the index:
Designate one year as the base year.
CPI= (price of basket in current year/ price of
basket in base year)x100
Calculating CPI: Various Steps
5. Calculate the Inflation Rate: Use the CPI to
calculate the inflation rate.
 Inflation rate is the percentage change in the
price index from the preceding period.
What’s in the CPI’s Basket?
Household
10.0%
Recreation
10.4%
Clothing
6.6%
Alcohol
4.5% Health
4.3%
Shelter
27.9%
Food
18.0%
Transportation
18.3%
CPI Monthly Index: Nov 2003
Canada
Same month last year
Previous
month
Nov-03
Change from
previous month
1992 = 100
Change from
same month last
year
%
All items
120.8
122.4
122.7
0.2
1.6
Food
120.4
121.1
122.3
1
1.6
Shelter
115.7
118.2
118.3
0.1
2.2
114
115.1
114.9
-0.2
0.8
Clothing and footwear
105.2
105
104.2
-0.8
-1
Transportation
139.2
139.7
140.9
0.9
1.2
Health and personal care
116.2
117.7
118
0.3
1.5
Recreation, education and reading
126.7
128.3
127.5
-0.6
0.6
Alcoholic beverages and tobacco products
131.9
137
137.6
0.4
4.3
121
122.7
122.8
0.1
1.5
All items excluding energy
119.4
121.1
121.6
0.4
1.8
Energy
136.2
137
135.4
-1.2
-0.6
Household operations and furnishings
Special aggregates
All items excluding food
Source: Statistics Canada, CANSIM, table 326-0001 and Catalogue nos. 62-001-XPB and 62-010-XIB.
Problems in Measuring The Cost of
Living
The CPI is not a perfect measure of the “cost of
living.”
Three reasons/problems:
Substitution Bias: Consumers substitute toward
goods that have become relatively less expensive
Introduction of new goods: With greater variety
consumers need fewer dollars to maintain any
given standard of living
Unmeasured quality change: Quality impacts on
the value of the currency
The Consumer Price Index versus the GDP
Deflator
The CPI:
includes only consumption goods
includes the cost of imports
is a fixed bundle of goods
The GDP Price Deflator:
includes all final goods and services
excludes imports
uses a current bundle of goods
Correcting Economic Variables for the Effects of
Inflation
To convert (inflate) past wages and prices
into current terms:
Current Year Dollars =
Past Year Nominal Value X [(Price index in current year) ÷
(Price index in past year)]
Correcting Economic Variables for the Effects of
Inflation
To convert (deflate) current wages and
prices into past year terms:
Value in Past Year Dollars =
Current Year Value X [(Price index in past year) ÷ (Price
index in current year)]
Indexation
Indexation is the automatic correction of a
dollar amount for the effects of inflation by law
or contract. E.g., COLA
Real interest rate= Nominal interest rateInflation rate
Inflation in Canada: CPI inflation