1 Measuring the Cost of Living Professor Chris Adam Australian Graduate School of Management University of Sydney and University of New South Wales

2 INTRODUCTION How to compare dollar-based data from one period to another? Use of index numbers –Consumer Price Index –GDP Deflator –Real interest rates –Real exchange rates

3 CONSUMER PRICE INDEX Measure of overall cost of goods and services bought by typical consumer Monthly measure based on “basket” of consumption goods and services Selection of basket content, appropriate prices, and base year Inflation rate calculation Producer Price Index

4 INFLATION

5 PROBLEMS IN COL MEASUREMENT Substitution bias –If price changes not uniform, consumers may alter consumption basket contents –“chaining” CPI measures to allow for changing baskets Introduction of new goods –New goods offer more variety, to enhance value of dollars spent and reduce “cost of standard of living”

6 PROBLEMS IN COL MEASUREMENT Unmeasured quality change –Deterioration of quality reduces value of dollar spent on good –Adjustment to prices to allow for change of quality Asset price inflation versus g&s (flow) inflation

7 EXPECTATIONS OF INFLATION

8 GDP DEFLATOR vs CPI GDP deflator measures domestic production but CPI includes foreign g&s GDP basket is actual production but CPI is fixed basket

9 AUSTRALIAN GDP DEFLATOR vs CPI

10 USES OF INFLATION CORRECTION Dollar figures from different times Indexation –Basic wage claims –Pension benefits –Public utility prices –Bond values Real and nominal interest rates Real and nominal exchange rates

11 INTERNATIONAL PRICE INDICES