PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
MEASURING THE
COST OF LIVING
Chapter 6
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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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Jirsak/Shutterstock
 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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Problems in Measuring the Cost of Living
Don't inflate inflation
Special to the Financial Post, Financial
Post Wednesday, February 16, 2011
http://opinion.financialpost.com/2011/02/16/dont-inflate-inflation/
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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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Classroom Activity
Create a Student Price Index
Take-Home Assignment
Pick real transactions prices for goods that you actually
purchase. If the indices will be used to calculate the
inflation rate, you should save a copy of this assignment
in a safe place. You should not use prices from
catalogues since such prices won’t be subject to change
over the semester.
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Classroom Activity
Create a Student Price Index (continued)
Your mission: Make up a personalized student price
index.
1. Choose five (or more) different products—be specific,
for example: unleaded gasoline, Molson Canadian beer
2. Pick a quantity for each product—for example, 15
litres of gasoline, a 12-pack of Molson Canadian beer
3. Find the actual price for each product.
4. Calculate the total cost of buying these products.
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THE END
Chapter 6
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