Econ 102 Chap 11

7/27/2019 Econ 102 Chap 11

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Chap 11, Mankiw - Measuring cost of

living

• The price indices – consumer, producer

• Issues related to the measurement of cost of living

• Adjusting variables for the rate of inflation

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I. The price indices

the consumer price index (CPI)

the producer price index (PPI)

steps in calculating CPI and measuring cost

1.

2.

3.

4.

5.

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Calculating the Consumer Price Index and

the Inflation Rate: An Example Step 1:Survey Consumers to Determine a Fixed

Basket of Goods

4 hot dogs, 2 hamburgers

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the Inflation Rate: An Example

Year

Price of

Hot dogs

Price of

Hamburgers

2001 $1 $2

2002 $2 $3

2003 $3 $4

Step 2: Find the Price of Each Good in Each Year

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the Inflation Rate: An Example

Step 3: Compute the Cost of the Basket of Goods in

Each Year

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the Inflation Rate: An Example Step 4: Choose One Year as the Base Year (2001) and

Compute the Consumer Price Index in Each Year

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the Inflation Rate: An Example Step 5: Use the Consumer Price Index to Compute the

Inflation Rate from Previous Year

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Housing Food/Beverages Transportation Medical Care

Apparel Recreation Other Education and communication

What’s in the CPI’s Basket?

40%

16%

17%

6%

5%

6%5% 5%

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II. Issues in the measurement of cost of living

A. Problems in constructing the CPI

1. Substitution bias

Consumers substitute toward goods

and away

The basket

The index _____________ the increase in cost of living by not

considering consumer substitution.

ex:

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2. Introduction of new goods

The basket

New products result in , which in turn makes eachdollar

ex:

3. Unmeasured quality change

If the quality of a good rises from one year to the next, the valueof a dollar , even if the price of the good .

By not

ex:

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B. The GDP Deflator versus the Consumer Price Index

Both the GDP deflator and the consumer price index measures how

quickly prices are rising - two important differences between thetwo,

1. The GDP deflator reflects the prices of all goods and services

and includes

The CPI reflects the prices of all goods and services

2. The CPI compares the price of a fixed basket of goods & services

The GDP deflator compares the price of currently

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1965

Percent

per Year 15

10

5

01970 1975 1980 1985 1990 1995 2000

CPI

Two Measures of Inflation

GDP deflator

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III. Correcting for effects of inflation

deflating dollar figures from different times

salary in 2006 dollars = salary in 2000 dollars x

Suppose US economy has a 3% inflation rate. If the CPI for 2000 is

100, (price level in 2006/price level in 2000) =

A person getting $50,000 in 2000 must get

today, in order to enjoy the same standard of living

indexation of contracts

The above formula is very often used to write salary or other

financial contracts

real and nominal interest rates

Real interest rate = nominal interest rate – inflation rate

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1965

Interest Rates

(percent per year)

15

10

5

0

-51970 1975 1980 1985 1990 1995 1998

Nominal

interest rate

Real interest rate

Real and Nominal Interest Rates

Documents

Econ 102 Chap 11