The CPI and the
Cost of Living
CHAPTER
15
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain what the Consumer Price Index (CPI) is and
how it is calculated.
2
Explain the limitations of the CPI and describe other
measures of the price level.
3
Adjust money values for inflation and calculate real
wage rates and real interest rates.
15.1 THE CONSUMER PRICE INDEX
Consumer Price Index (CPI) is a measure of the
average of the prices paid by urban consumers for a
fixed market basket of consumer goods and services.
The BLS calculates the CPI every month.
We can use these numbers to compare what a fixed
basket of goods costs this month with what it cost in
some previous month.
15.1 THE CONSUMER PRICE INDEX
Reading the CPI Numbers
The CPI is defined to equal 100 for a period called the
reference base period.
Reference base period is a period for which the CPI
is defined to equal 100. Currently, the reference base
period is 19821984.
15.1 THE CONSUMER PRICE INDEX
In August 2007, the CPI was 207.9.
The average of the prices paid by urban consumers for
a fixed market basket of consumer goods and services
was 107.9 percent higher in August 2007 than it was on
the average during 19821984.
In July 2007, the CPI was 208.3.
The average of the prices paid by urban consumers for
a fixed market basket of consumer goods and services
decreased by 0.4 of a percentage point in August 2007.
15.1 THE CONSUMER PRICE INDEX
Constructing the CPI
Three stages:
• Selecting the CPI basket
• Conducting the monthly price survey
• Calculating the CPI
15.1 THE CONSUMER PRICE INDEX
The CPI Basket
Make the relative importance of the items in the CPI
basket the same as in the budget of an average urban
household.
The CPI is calculated each month, but the CPI basket is
not updated each month.
The current CPI basket in 2007 is based on information
obtained from the Consumer Expenditure Survey
conducted during 2005.
15.1 THE CONSUMER PRICE INDEX
Figure 15.1 shows the CPI basket.
This shopping cart is filled with the items that an average
household buys.
15.1 THE CONSUMER PRICE INDEX
The Monthly Price Survey
Each month, BLS employees check the prices of the
80,000 goods and services in the CPI basket in 30
metropolitan areas.
Because the CPI measures price changes, it is
important that the prices recorded refer to exactly the
same items.
15.1 THE CONSUMER PRICE INDEX
Calculating the CPI
The CPI calculation has three steps:
• Find the cost of the CPI basket at base period
prices.
• Find the cost of the CPI basket at current period
prices.
• Calculate the CPI for the base period and the
current period.
Table 15.1 on the next slide shows a simplified CPI
calculation in which we assume a base period of 2005.
15.1 THE CONSUMER PRICE INDEX
15.1 THE CONSUMER PRICE INDEX
CPI =
Cost of CPI basket at current period prices
x 100
Cost of CPI basket at base period prices
For 2005, the CPI is:
For 2008, the CPI is:
$50
x 100 = 100
$50
$70
$50
x 100 = 140
15.1 THE CONSUMER PRICE INDEX
Measuring Inflation
Inflation rate is the percentage change in the price
level from one year to the next.
Inflation rate =
CPI in current year  CPI in previous yearx 100
CPI in previous year
Inflation rate =
140  120 x 100 = 16.7 percent
120
15.1 THE CONSUMER PRICE INDEX
Figure 15.2 shows the CPI in part (a) and the inflation rate
in part (b).
15.1 THE CONSUMER PRICE INDEX
In part (a), the price level has increased every year. The
rate of increase was rapid during the early 1980s and
slower during the 1990s.
15.1 THE CONSUMER PRICE INDEX
In part (b), the inflation rate was high during the early
1980s, but low during the 1990s.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Cost of living index is a measure of changes in the
amount of money that people would need to spend to
achieve a given standard of living.
The CPI does not measure the cost of living because
• It does not measure all the components of the cost
of living
• Some components are not measured exactly
So the CPI is possibly a biased measure.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
 Sources of Bias in the CPI
The potential sources of bias in the CPI are
•
•
•
•
New goods bias
Quality change bias
Commodity substitution bias
Outlet substitution bias
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
New Goods Bias
• New goods do a better job than the old goods that
they replace, but cost more.
• The arrival of new goods puts an upward bias into
the CPI and its measure of the inflation rate.
Quality Change Bias
• Better cars and televisions cost more than the
versions they replace.
• A price rise that is a payment for improved quality
is not inflation but might get measured as inflation.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Commodity Substitution Bias
• If the price of beef rises faster than the price of
chicken, people buy more chicken and less beef.
• The CPI basket doesn’t change to allow for the
effects of substitution between goods.
Outlet Substitution Bias
• If prices rise more rapidly, people use discount
stores more frequently.
• The CPI basket doesn’t change to allow for the
effects of outlet substitution.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
 The Magnitude of the Bias
The Boskin Commission estimated the bias to be 1.1
percentage points per year.
If the measured inflation rate is 3.1 percent a year, most
likely the actual inflation rate is 2.0 percent a year.
To reduce the bias, the BLS has decided to increase the
frequency of its Consumer Expenditure Survey and
revise the CPI basket every two years.
When the BLS revises the CPI basket, the reference
base period does not change.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Two Consequences of the CPI Bias
Two main consequences of the bias in the CPI are
• Distortion of private contracts
• Increases in government outlays and decreases in
taxes
Distortion of Private Contracts
Many wage contracts are linked to the CPI.
If the CPI is biased, these contracts might deliver an
outcome different from that intended by the parties.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Suppose that the UAW and GM sign a 3 year wage
deal: In the first year, the wage will be $30 an hour and
will rise by the inflation rate in the next two years.
If the inflation rate is 5 percent a year, the wage rises to
$31.50 an hour in the second year and $33.08 an hour
in the third year.
But if the actual inflation rate is 2 percent a year, the
intended wages in the second and third years are
$30.90 an hour and $31.83 an hour.
The workers’ gain is GM’s loss. With thousands of
workers, GM’s loss would be millions of dollars over the
3 years.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Increases in Government Outlays and Decreases in
Taxes
Close to a third of federal government outlays are linked
directly to the CPI.
The CPI is used to adjust
• 48 million Social Security benefit payments
• 22 million food stamp payments
• 4 million pensions for retired military personnel,
federal civil servants, and their surviving spouses
• the budget for 27 million school lunches
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
The CPI is used to adjust the income levels at which
higher tax rates apply.
Because tax rates on large incomes are higher than
those on small incomes as incomes rise, the burden of
taxes would rise relentlessly if these adjustments were
not made.
To the extent that the CPI is biased upward, the tax
adjustments over-compensate for rising prices and
decrease the amount paid in taxes.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Alternative Measures of the Price Level
Several alternative measures of the price level are
available.
Here we look at
• The GDP deflator
• The personal consumption expenditures deflator
(PCE deflator)
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
GDP Deflator
The GDP deflator is an average of current prices of all
the goods and services included in GDP expressed as a
percentage of base-year prices.
GDP deflator = (Nominal GDP  Real GDP)  100.
The GDP deflator is a measure of the price level and
the percentage change in the GDP deflator is a
measure of the inflation rate.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Two key differences between the GDP deflator and the CPI
result in different estimates of the price level and inflation
rate.
1.The GDP deflator uses the prices of all the goods and
services in GDP whereas the CPI uses prices of
consumption goods and services only.
2. The GDP deflator weights each item using
information about current as well as past quantities.
In contrast, the CPI weights each item using
information from a past consumer expenditure survey.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
Because the GDP deflator uses information on current
year quantities, it includes new goods and quality
improvements and even allows for substitution effects of
both commodities and retail outlets.
So in principle, the GDP deflator is not subject to the
biases of the CPI.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
In practice, the GDP deflator suffers from some of the
CPI’s problems because the Commerce Department
does not directly measure the physical quantities of all
the goods and services that are produced.
Instead, to estimate quantities, the Commerce
Department divides expenditures by price indexes.
And one of these price indexes is the CPI.
So the biased CPI injects a bias into the GDP deflator.
15.2 THE CPI AND OTHER PRICE LEVEL MEASURES
PCE Deflator
The PCE deflator is an average of current prices of all
the goods and services included in the consumption
expenditure component of GDP expressed as a
percentage of base-year prices.
The PCE deflator has the same advantages as GDP
deflator—it uses current information on quantities and to
some degree overcomes the sources of bias in the CPI.
The PCE deflator, like the CPI, is a possible measure of
the cost of living.
15.2 THE CPI AND OTHER…
Figure 15.3 shows the three
measures of inflation in part (a)
and the corresponding measures
of the price level in part (b).
The three measures of the
inflation rate fluctuate together,
but the CPI measure rises more
rapidly than the GDP deflator
measure or the PCE deflator
measure.
15.2 THE CPI AND OTHER …
In part (b), the CPI measure of
the price level is the highest and
the PCE deflator lies between
the CPI and the GDP deflator.
The CPI measure overstates the
inflation rate.
15.3 NOMINAL AND REAL VALUES
Dollars and Cents at Different Dates
To compare dollar amounts at different dates, we need
to know the CPI at those dates.
Convert the price of a 2-cent stamp in 1907 into its 2007
equivalent:
Price of stamp in 2007 dollars =
Price of stamp in 1907 dollars x
CPI in 2007
CPI in 1907
= 2 cents x
207.2
10
= 41 cents
15.3 NOMINAL AND REAL VALUES
Nominal and Real Values in Macroeconomics
Macroeconomics makes a big issue of the distinction
between nominal values and real values:
• Nominal GDP and real GDP
• Nominal wage rate and real wage rate
• Nominal interest rate and real interest rate
We studied the distinction between and calculation of
nominal and real GDP in Chapter 21. Here, we’ll look at
the other two.
15.3 NOMINAL AND REAL VALUES
Nominal and Real Wage Rates
Nominal wage rate Iis the average hourly wage rate
measured in current dollars.
Real wage rate is the average hourly wage rate
measured in the dollars of a given reference base year.
15.3 NOMINAL AND REAL VALUES
To calculate the real wage rate, we divide the nominal
wage rate by the CPI and multiply by 100.
That is,
Nominal wage rate in 2006
Real wage rate in 2006 =
Real wage rate in 2006 =
x 100
CPI in 2006
$16.73
201.6
x 100 = $8.23
The $8.23 amount is in 19821984 dollars.
15.3 NOMINAL AND REAL VALUES
Figure 15.4 shows
nominal and real wage
rates: 1982–2006.
The nominal wage rate
has increased every
year since 1982.
The real wage rate
decreased slightly from
1982 through the mid1990s, after which
increased slightly.
15.3 NOMINAL AND REAL VALUES
Nominal and Real Interest Rates
Nominal interest rate is the percentage return on a
loan expressed in dollars.
Real interest rate is the percentage return on a loan,
calculated by purchasing power—the nominal interest
rate adjusted for the effects of inflation.
Real interest rate = Nominal interest rate – Inflation rate.
15.3 NOMINAL AND REAL VALUES
Figure 15.5 shows real
and nominal interest
rates: 1967–2007.
During the 1970s,
the real interest rate
became negative.
The nominal interest
rate increased during
the high-inflation 1980s.