1. Measuring the Cost of Living24
Measuring the Cost of Living

2. Measuring the Cost of Living
Inflation refers to 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.

3. Measuring inflation
Inflation is a fact of life: very few exceptions aside, all economies in the world have some experience with inflation
A small number of economies, among them Turkey, know very high and persistent inflation
In this chapter, we take our first shot at inflation
Explaining inflation will have to wait a little
Now we shall look into measuring inflation
We already encountered a measure of inflation with the GDP deflator
Inflation is usually measured by the use of price indexes such as the Consumer Price Index and the Producer or Wholesale Price Index

4. THE CONSUMER PRICE INDEX
The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.
It is used to monitor changes in the cost of living over time.

5. THE CONSUMER PRICE INDEX
When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living.

6. Consumer price index – CPI
In Turkey the consumer inflation is measured by Tüketici Fiyatları Endeksi – TÜFE – calculated by TÜİK
Other institutions, such as the ITO – Istanbul Chamber of Commerce – also calculates indexes to measure changes in cost of living

7. How the Consumer Price Index Is Calculated
Fix the Basket: Determine what prices are most important to the typical consumer.
TUIK identifies a market basket of goods and services the typical consumer buys.
The TUIK conducts monthly consumer surveys to set the weights for the prices of those goods and services.

8. Calculating price indexes
The consumption basket is determined by TÜİK through a “Consumer Survey” of the population
The previous index is based on a consumer survey undertaken in 2003
All the goods and services consumed by the typical household as observed in the survey during 2003 are in the basket

9. How the Consumer Price Index Is Calculated
Find the Prices: Find the prices of each of the goods and services in the basket for each point in time.

10. How the Consumer Price Index Is Calculated
Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services at different times.

11. The cost of the basket
TÜİK collects the prices from different retail outlets about the prices of the goods and services in the basket three times every month
Thus obtains an average price of the month for each item
Then multiplies each average price with its weight in the basket and adds them up
In this way the total cost of filling up the basket in that month is calculated
By comparing the cost of the basket this month with the previous month, or the same month a year ago, or that of the base period allows the calculation of inflation

12. How the Consumer Price Index Is Calculated
Choose a Base Year and Compute the Index:
Designate one year as the base year, making it the benchmark against which other years are compared.
Compute the index by dividing the price of the basket in one year by the price in the base year and multiplying by 100.

13. How the Consumer Price Index Is Calculated
Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

14. How the Consumer Price Index Is Calculated
The Inflation Rate
The inflation rate is calculated as follows:

15. Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
Copyright©2004 South-Western

16. Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
Copyright©2004 South-Western

17. Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
Copyright©2004 South-Western

18. Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
Copyright©2004 South-Western

19. Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example
Copyright©2004 South-Western

20. How the Consumer Price Index Is Calculated
Calculating the Consumer Price Index and the Inflation Rate: Another Example
Base Year is 2002.
Basket of goods in 2002 costs $1,200.
The same basket in 2004 costs $1,236.
CPI = ($1,236/$1,200)  100 = 103.
Prices increased 3 percent between 2002 and 2004.

21. Same inflation, different figures
In the short run, the key indicator of inflation is the monthly figure
TÜİK publishes on the 3rd day of each month the inflation for the previous month
Annual inflation compares the change in prices in 12 months
Year-end inflation is annual inflation for the calender year (January to December)
Average annual inflation is calculated by taking the average of the annual inflation figures of the last 12 months
Monthly inflation can be very volatile while average inflation is more stable

22. Composition of the CPI basket

23. Details of CPI index TÜİK publishes other details of the CPI index
Subdivisions of major categories: for exemple “Food and Beverages” is divided into three: Food, Beverages, Cigarettes and Tobacco
Regional indexes: separate indexes for many cities : Istanbul, Ankara, İzmir, etc.
Different income groups: wage earners, rural households, etc.
Developed economies also publish detailed local CPI figures such as “white collar employees in county X”
Or “CPI excluding food”, “CPI excluding energy”, “CPI excluding rent” etc.

24. Problems in Measuring the Cost of Living
The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.

25. Problems in Measuring the Cost of Living
Substitution bias
Introduction of new goods
Unmeasured quality changes

26. Problems in Measuring the Cost of Living
Substitution Bias
The basket does not change to reflect consumer reaction to changes in relative prices.
Consumers substitute toward goods that have become relatively less expensive.
The index overstates the increase in cost of living by not considering consumer substitution.

27. Problems in Measuring the Cost of Living
Introduction of New Goods
The basket does not reflect the change in purchasing power brought on by the introduction of new products.
New products result in greater variety, which in turn makes each dollar more valuable.
Consumers need fewer dollars to maintain any given standard of living.

28. Problems in Measuring the Cost of Living
Unmeasured Quality Changes
If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same.
If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
The TÜIK tries to adjust the price for constant quality, but such differences are hard to measure.

29. Problems in Measuring the Cost of Living
The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living.
The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices.
The CPI overstates inflation by about 1 percentage point per year.

30. The GDP Deflator versus the Consumer Price Index
The GDP deflator is calculated as follows:

31. The GDP Deflator versus the Consumer Price Index
The TÜIK calculates other prices indexes:
The index for different regions within the country.
The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers.

32. Wholesale Price Index
All economies calculate a second inflation index trying to measure the input costs of businesses called “Producer Prices Index”
In Turkey it was called the Wholesale Price Index – WPI (Toptan Eşya Fiyatları Endeksi – TEFE)
TÜİK computes a basket of goods used as inputs by the firms in the economy and uses the same base year as the CPI (1994)
WPI distinguishes between prices of private sector firms and public sector firms
It has four major categories: agriculture (22.2 %), Mining (2.5 %), Manufacturing (71.1 %) and Energy, Gas & Water (4.2 %)

33. Comparing WPI and CPI
CPI includes only final goods bought by consumers; WPI has only intermediate goods
Bread, cheese, shirts, socks, skirts, ties are in CPI
Wheat, flour, milk, yarn, cloth, etc. are in WPI
Newspapers, cigarettes are in CPI, print paper and tobacco are in WPI
50 % of CPI is services and residential rent
Eating at a restaurant, going to a movie, visiting a doctor, taking a bus are only in CPI, there are no services in WPI
Renting a house is in CPI, but renting an office is not in WPI

34. Turkey: monthly inflation

35. Turkey: annual inflation

36. Turkey: average and annual CPI

37. Turkey: average and annual WPI

38. A.S.Akat
EC 102 – Chapter 23

39. CPI details: February 2002

40. WPI details: February 2002

41. The GDP Deflator versus the Consumer Price Index
Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising.
There are two important differences between the indexes that can cause them to diverge.

42. The GDP Deflator versus the Consumer Price Index
The GDP deflator reflects the prices of all goods and services produced domestically, whereas...
…the consumer price index reflects the prices of all goods and services bought by consumers.

43. The GDP Deflator versus the Consumer Price Index
The consumer price index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the TÜİK change the basket)...
…whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

44. Figure 2 Two Measures of Inflation
Percent
per Year 15
CPI 10
GDP deflator 5
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western

45. CPI and the GDP deflator
Economists and policymakers use both the CPI and the GDP deflator to analyse inflation
There are important differences between the two
Consumer Price Index
includes only consumer goods,
includes imports
is measured using a fixed basket
Gross Domestic Product deflator
includes all goods and services domestically produced
excludes imports,
is measured using currently produced goods and services

46. Turkey: CPI, WPI and GDP deflator

47. Correcting for inflation
You often hear parents saying something like “we bought this flat for TL in 1970” and wonder about how much it was worth today
Even at low leves of inflation such as 2-3 % per year, over long periods of time the purchasing power of money changes substantially and needs to be corrected for comparaisons
Price indexes are used to make this correction by inflating the original price to current prices
Price Index2002
Price Index1970
Price2002 = Price1970 x

48. Indexation
Price indexes are widely used in the economy to correct for the effects of inflation
If a payment is automatically corrected for inflation by contract or by law, the payment in question is said to be indexed to inflation
The government indexed pensions of Social Security (SSK emeklileri) to CPI: it means pensioners automatically get an increase equal to the CPI change of previous month
The tax system is also indirectly indexed to annual inflation with changes in tariffs
High inflation countries have developed sophistic-ated indexation systems but not in Turkey

49. Real and nominal interest
It is very important to correct interest rates for inflation
Nominal interest rate is the actual interest rate that we see in the market place
Real interest rate is corrected for inflation
Assume nominal interest rate is 70 % p.a. and annual CPI inflation is 50 %
For 1 million TL, after one year you get 1.7 million TL with interest but your 1 million TL has in the meanwhile became 1.5 million TL with inflation
Your real interest is only 200 million TL, the rest of the interest you received (500 million TL) goes to offset your loss from inflation

50. Calculating real interest rate
How do you calculate the real interest rate?
For low inflation (below 10 % p.a.) a simple rule is:
Real interest rate = nominal interest rate –inflation
For example, if inflation is 3 % and the nominal interest rate is 6 %, the real interest rate is 3 %

51. At higher inflation this rule is not applicable.
A.S.Akat
EC 102 – Chapter 23
At higher inflation this rule is not applicable.
Let us call r = real interest rate, i = nominal interest rate and  = inflation rate, all in percentages
The full formula becomes:
r = [ (1 + i / 1 + ) – 1 ] x 100
For i= 70 % and  = 50 % we get r = 13.3 %
r = (1.7 / 1.5) – 1 = (1.13 – 1) x 100 = 13 %

52. US: nominal & real interest
Interest Rates
(percent per year) 15
Nominal
interest rate 10 5
Real interest rate -5
1965
1970
1975
1980
1985
1990
1995 3

53. Turkey: nominal & real interest

54. Indexation
When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation.

55. Real and Nominal Interest Rates
Interest represents a payment in the future for a transfer of money in the past.

56. Real and Nominal Interest Rates
The nominal interest rate is the interest rate usually reported and not corrected for inflation.
It is the interest rate that a bank pays.
The real interest rate is the nominal interest rate that is corrected for the effects of inflation.

57. Real and Nominal Interest Rates
You borrowed $1,000 for one year.
Nominal interest rate was 15%.
During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%

58. Figure 3 Real and Nominal Interest Rates
(percent
per year) 15 10
Nominal interest rate 5
Real interest rate –5
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western

59. Summary
The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year.
The index is used to measure the overall level of prices in the economy.
The percentage change in the CPI measures the inflation rate.

60. Summary
The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality.
Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.

61. Summary
The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed.
In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

62. Summary
Dollar figures from different points in time do not represent a valid comparison of purchasing power.
Various laws and private contracts use price indexes to correct for the effects of inflation.
The real interest rate equals the nominal interest rate minus the rate of inflation.