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MEASURING THE COST OF LIVING

In this chapter, look for the answers to these questions: What is the Consumer Price Index (CPI)?

How is CPI calculated? What’s it used for?

What are the problems with the CPI? How serious are they?

How does the CPI differ from the GDP deflator?

How can we use the CPI to compare dollar amounts from different years? Why would we want to do this, anyway?

How can we correct interest rates for inflation?

The Consumer Price Index (CPI)

Measures the typical consumer’s cost of living.

CPI is used as the basis of Cost of Living Adjustments (COLAs) in many contracts and in Social Security.

COLA is an adjustment made to a salary structure to account for the change in CPI.COLA is an adjustment made to a salary structure to account for the change in CPI.

COLA adjustments are then made to individual employee salaries based on company policy and are typically granted to employees as "general salary increases".

COLA adjustments are then made to individual employee salaries based on company policy and are typically granted to employees as "general salary increases".

How the CPI Is Calculated

1. Fix the “basket.”The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.”

2. Find the prices.The BLS collects data on the prices of all the goods in the basket.

3. Compute the basket’s cost.Use the prices to compute the total cost of the basket.

How the CPI Is Calculated (Continued)

4. Choose a base year and compute the index. The CPI in any year equals:

5. Compute the inflation rate: The percentage change in the CPI from the preceding period.

CPI =100 xcost of basket in current year

cost of basket in base year

CPI this year – CPI last year

CPI last yearinflation

ratex 100%=

EXAMPLE

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3.00

$2.50

$2.00

price of latte

$122005

$112004

$102003

price of pizza

year

Compute CPI in each year:

2003: 100 x ($60/$60) = 100

2004: 100 x ($69/$60) = 115

2005: 100 x ($78/$60) = 130

15%

13%

Inflation rate:Inflation rate:

15% = [(115/100) -1] * 100 and13% = [(130/115) -1] * 100

15% = [(115/100) -1] * 100 and13% = [(130/115) -1] * 100

basket: {4 pizzas, 10 lattes} & 2003 is Base yearbasket: {4 pizzas, 10 lattes} & 2003 is Base year

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Calculate the CPICalculate the CPI

18

The basket contains 20 movie tickets and 10 textbooks.

The table shows their prices for 2004-2006.

The base year is 2004.

A. How much did the basket cost in 2004?

B. What is the CPI in 2005?

C. What is the inflation rate from 2005-2006?

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers

19

A. How much did the basket cost in 2004?

Cost of the basket =($10 x 20) + ($50 x 10) = $700

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60



20

B. What is the CPI in 2005?

cost of basket in 2005= ($10 x 20) + ($60 x 10) = $800

CPI in 2005 = 100 x ($800/$700) = 114.3

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60


You must compute the cost of the basket in 2005 (and use your answer from part A) to find the CPI in 2005. You must compute the cost of the basket in 2005 (and use your answer from part A) to find the CPI in 2005.


21

C. What is the inflation rate from 2005-2006?

cost of basket in 2006= ($12 x 20) + ($60 x 10) = $840

CPI in 2006 = 100 x ($840/$700) = 120

Inflation rate = {[(120 – 114.3)]/114.3} * 100 = 5%

movie tickets

text-books

2004 $10 $50

2005 $10 $60

2006 $12 $60


What’s in the CPI’s Basket?

42%

17%

15%

6%

6%

6%4% 4% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education andcommunicationApparel

Other

Problems With the CPI 1- Substitution Bias mUlehtu

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others.enAeBlevlayUrGaceGayéføekIneLIgelOn

Consumers substitute toward goods that become relatively cheaper.

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The CPI misses this substitution because it uses a fixed basket of

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Thus, the CPI overstates increases in the cost of living.

Problems With the CPI (Continued) 2- Introduction of New Goods

When new goods become available, variety increases, allowing consumers to find products that more closely meet their needs. nUveBlEdlTMnijfµÍvaEtgEtmanGnuPaBeTAelIéfø dUcenHk¾vaGaceGayGñkeRbIR)as; eTArkTMnijNaEdlmanéføefakCag.

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Problems With the CPI (Continued) 3- Unmeasured Quality Change

Improvements in the quality of goods in the basket increase the value of each dollar.

The BLS tries to account for quality changes, but probably misses some quality improvements, as quality is hard to measure.


Problems With the CPI (Continued)

Each of these problems causes the CPI to overstate cost of living increases.

The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year.

This is important, because Social Security payments and many contracts have COLAs tied to the CPI.

Two Measures of Inflation

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent per Year

CPI GDP deflator

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent per Year

CPI GDP deflator

Imported consumer goods: included in CPI excluded from GDP deflator

Imported consumer goods: included in CPI excluded from GDP deflator

The basket: CPI uses fixed basket GDP deflator uses basket of

currently produced goods & services.This matters if different prices are changing by different amounts.

The basket: CPI uses fixed basket GDP deflator uses basket of

currently produced goods & services.This matters if different prices are changing by different amounts.

Capital goods: excluded from CPI included in GDP deflator

(if produced domestically)

Capital goods: excluded from CPI included in GDP deflator

(if produced domestically)

Contrasting the CPI and GDP Deflator

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : CPI vs. GDP deflatorCPI vs. GDP deflator

29

In each scenario, determine the effects on the CPI and the GDP deflator.

A. Starbucks raises the price of Frappuccinos.

B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

C. Armani raises the price of the Italian jeans it sells in the U.S.


30

A. Starbucks raises the price of Frappuccinos.

The CPI and GDP deflator both rise.

B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

The GDP deflator rises, the CPI does not.

C. Armani raises the price of the Italian jeans it sells in the U.S.

The CPI rises, the GDP deflator does not.

Correcting Variables for Inflation:Comparing Dollar Figures from Different Times

Inflation makes it harder to compare dollar amounts from different times.

We can use the CPI to adjust figures so that they can be compared.

EXAMPLE: The High Price of Gasoline

Price of a gallon of regular unleaded gas:

$1.42 in March 1981

$2.50 in August 2005

To compare these figures, we will use the CPI to express the 1981 gas price in “2005 dollars.”Question: what gas in 1981 would have cost if the cost of living were the same then as in 2005.

Answer: Multiply the 1981 gas price by the ratio of the CPI in 2005 to the CPI in 1981. Answer: Multiply the 1981 gas price by the ratio of the CPI in 2005 to the CPI in 1981.

196.4$2.50/gallon8/2005

88.5$1.42/gallon3/1981

CPIPrice of gasDate

Solution: The High Price of Gasoline

1981 gas price in 2005 dollars

= $1.42 x 196.4/88.5 = $3.15

After correcting for inflation, gas was more expensive in 1981. See next slide.

$2.50/gallon

$3.15/gallon

Gas price in 2005 dollars

Thus, if the cost of living in 1981 had been the same as it was in 2005, the price of gas in 1981 would have been $3.15/gallon.

Thus, if the cost of living in 1981 had been the same as it was in 2005, the price of gas in 1981 would have been $3.15/gallon.

AA CC TT II VV E LE L EE AA RR NN II NN G G 33: : ExerciseExercise

Suppose that in 1980: CPI = 90, and average starting salary for economic majors = $24,000

Suppose that today: CPI = 180, and average starting salary for economic majors = $50,000

Are economic majors better off today or in 1980?

34


35

Solution

Convert 1980 salary into “today’s dollars”

$24,000 x (180/90) = $48,000.

After adjusting for inflation, salary is higher today than in 1980.

1980: CPI = 90, avg starting salary for econ majors = $24,000

Today: CPI = 180, avg starting salary for econ majors = $50,000

Correcting Variables for Inflation:Indexation

For example, the increase in the CPI automatically determines:

• the COLA in many multi-year labor contracts.

• the adjustments in Social Security payments and federal income tax brackets.

A dollar amount is A dollar amount is indexedindexed for inflation for inflation if it is automatically corrected for inflation if it is automatically corrected for inflation

by law or in a contract.by law or in a contract.

Correcting Variables for Inflation (Continued):Real vs. Nominal Interest Rates

The nominal interest rate is:

• the interest rate which is not corrected for inflation.

The real interest rate is:

• corrected for inflation.

Real interest rate = (nominal interest rate) – (inflation rate)Real interest rate = (nominal interest rate) – (inflation rate)

Real and Nominal Interest Rates EXAMPLE

Suppose you deposited $1,000 for one year.

Suppose nominal interest rate in that year is 9%.

Suppose during that year, inflation is 3.5%.

Calculate the real interest rate. What happened to purchasing power of your $1000 ?

Real interest rate = Nominal interest rate – Inflation

= 0.09 – 0.035 = 0.055 = 5.5%

Thus, the purchasing power of the $1000 you deposited has grown by 5.5%.

Real and Nominal Interest Rates in the U.S.

-10

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Inte

rest

Rat

es

(per

cen

t p

er y

ear)

Nominal interest rate Real interest rate

-10

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Inte

rest

Rat

es

(per

cen

t p

er y

ear)

Nominal interest rate Real interest rate

CHAPTER 5 PART A UNEMPLOYMENT

In this chapter, look for the answers to these questions: How is unemployment measured?

What is the “natural rate of unemployment”?

Why are there always some people unemployed?

How is unemployment affected by unions and minimum wage laws?

What is the theory of efficiency wages, and how does it help explain unemployment?


Labor Force Statistics

Produced by Bureau of Labor Statistics (BLS), in the U.S. Department of Labor.

It is based on regular survey of 60,000 households.

And, also it is based on “adult population” (16 years or older).

Labor Force Statistics (Continued)

BLS divides population into 3 groups:

• 1- Employed: paid employees, self-employed, and unpaid workers in a family business.

• 2- Unemployed: people not working who have looked for work during previous 4 weeks.

• 3- Not in the labor force: everyone else.

The labor force is the total # of workers, including the employed and unemployed.

Take a goodnote of this

slide

labor force participation rate

(LFPR)

labor force

adult population= 100 x

Labor Force Statistics (Continued)

Labor force participation rate (LFPR): % of the adult population that is in the labor force:

Unemployment rate (“u-rate”): % of the labor force that is unemployed:

u-rate# of unemployed

labor force= 100 x

Take a goodnote of this

slide

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Calculate labor force statisticsCalculate labor force statistics

Compute the labor force, u-rate, adult population, and labor force participation rate using this data:

44

Adult population of the U.S.by group, January 2006

# of employed 143.1 million

# of unemployed 7.0 million

not in labor force 77.4 million


Labor force = employed + unemployed

= 143.1 + 7.0

= 150.1 million

U-rate = 100 x (unemployed)/(labor force)

= 100 x 7.0/150.1

= 4.7%

45


Population = labor force + not in labor force

= 150.1 + 77.4

= 227.5

LFPR = 100 x (labor force)/(population)

= 100 x 150.1/227.5

= 66.0%

46

ASSIGNMENT

Go to the following source to update the previous figures for June 2009.

http://www.docstoc.com/docs/8072005/The-Employment-Situation-from-BLS-June-2009



Labor Market Statistics for Different Groups

The BLS publishes the following statistics (next four slides) for demographic groups within the population.

These data reveal widely different labor market experiences for different groups.

Labor Market Statistics for Whites & Blacks,

DATE______

Adults (20 yrs & older)

u-rate LFPR

White, male % %

White, female % %

Black, male % %

Black, female % %

Students: use www.bls.gov, look for latest “employment situation.” and report to me in the next class.

Labor Market Statistics for Whites & Blacks,

DATE_____

Teens (16-19 yrs)

u-rate LFPR

White

Black


Labor Market Statistics for Other Groups, DATE______

All ages

u-rate LFPR

Asian

Hispanic


Labor Market Statistics by Education Level DATE: January 2006

Adults (25 yrs & older)

u-rate LFPR

less than h.s. 7.0% 46.0%

h.s. diploma 4.4 62.5

some college or assoc degree

3.5 72.5

bachelor’s degree or more

2.1 78.3

Students: use www.bls.gov, look for latest “employment situation.” and report to me in the next class.Students: use www.bls.gov, look for latest “employment situation.” and report to me in the next class.

LFPR by Sex, Since 1950

20

30

40

50

60

70

80

90

100

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Men

Women

Thanks for your attention.Thanks for your attention.

Documents

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