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7 The CPI and the Cost of Living CHAPTER

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C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Explain what the Consumer Price Index (CPI) is and how it is calculated. 1 Explain the limitations of the CPI as a measure of the cost of living. 2 Adjust money values for inflation and calculate real wage rates and real interest rates. 3

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**7.1 THE CONSUMER PRICE INDEX**

Consumer Price Index (CPI) A measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services.

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**7.1 THE CONSUMER PRICE INDEX**

Reading the CPI Numbers The CPI is defined to equal 100 for a period called the reference base period. Reference base period A period for which the CPI is defined to equal 100. Currently, the reference base period is 19821984.

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**7.1 THE CONSUMER PRICE INDEX**

In May 2005, the CPI was The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 94.4 percent higher in May 2005 than it was on the average during 19821984. In April 2005, the CPI was The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services decreased by 0.2 of a percentage point in May 2005.

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**7.1 THE CONSUMER PRICE INDEX**

Constructing the CPI Three stages: Selecting the CPI basket Conducting the monthly price survey Calculating the CPI

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**7.1 THE CONSUMER PRICE INDEX**

The CPI Basket Make the relative importance of the items in the CPI basket the same as in the budget of an average urban household. The CPI is calculated each month, but the CPI basket is not updated each month. The current CPI basket is based on information obtained from the Consumer Expenditure Survey conducted during 2001 and 2002.

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**7.1 THE CONSUMER PRICE INDEX**

Figure 7.1 shows the CPI basket. This shopping cart is filled with the items that an average household buys. Ask your students to make an estimate of their own baskets and compare them with the BLS basket.

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**7.1 THE CONSUMER PRICE INDEX**

The Monthly Price Survey Each month, BLS employees check the prices of the 80,000 goods and services in the CPI basket in 30 metropolitan areas. Because the CPI measures price changes, it is important that the prices recorded refer to exactly the same items. Surveying college textbook prices might capture the students’ attention. (See the IM for a detailed discussion).

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**7.1 THE CONSUMER PRICE INDEX**

Calculating the CPI The CPI calculation has three steps: Find the cost of the CPI basket at base period prices. Find the cost of the CPI basket at current period prices. Calculate the CPI for the base period and the current period.

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**7.1 THE CONSUMER PRICE INDEX**

Table 7.1 shows the consumer price index: a simplified CPI calculation.

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**7.1 THE CONSUMER PRICE INDEX**

Cost of CPI basket at current period prices Cost of CPI basket at base period prices x 100 CPI = For 2000, the CPI is: = 100 $50 x 100 For 2003, the CPI is: = 140 $70 $50 x 100

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**7.1 THE CONSUMER PRICE INDEX**

Measuring Inflation Inflation rate The percentage change in the price level from one year to the next. CPI in current year CPI in previous year CPI in previous year x 100 Inflation rate = Emphasize the distinction between the price level and the inflation rate. Do some calculations and have the students do some too. Inflation rate = = 16.7 percent 140 120 120 x 100

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**7.1 THE CONSUMER PRICE INDEX**

Figure 7.2 shows the CPI in part (a) and the inflation rate in part (b).

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**7.1 THE CONSUMER PRICE INDEX**

In part (a), the price level has increased every year. The rate of increase was rapid during the early 1980s and slower during the 1990s.

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**7.1 THE CONSUMER PRICE INDEX**

In part (b), the inflation rate was high during the early 1980s, but low during the 1990s.

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**7.2 THE CPI AND THE COST OF LIVING**

Cost of living index A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI does not measure the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure.

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**7.2 THE CPI AND THE COST OF LIVING**

Sources of Bias in the CPI The potential sources of bias in the CPI are New goods bias Quality change bias Commodity substitution bias Outlet substitution bias The IM contains a detailed explanation of how you might illustrate substitution bias.

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**7.2 THE CPI AND THE COST OF LIVING**

New Goods Bias New goods do a better job than the old goods that they replace, but cost more. The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. Quality Change Bias Better cars and televisions cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

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**7.2 THE CPI AND THE COST OF LIVING**

Commodity Substitution Bias If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesn’t change to allow for the effects of substitution between goods. Outlet Substitution Bias If prices rise more rapidly, people use discount stores more frequently. The CPI basket doesn’t change to allow for the effects of outlet substitution.

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**7.2 THE CPI AND THE COST OF LIVING**

The Magnitude of the Bias The Boskin Commission estimated the bias to be 1.1 percentage points per year. If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years. When the BLS revises the CPI basket, the reference base period does not change.

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**7.2 THE CPI AND THE COST OF LIVING**

Two Consequences of the CPI Bias Two main consequences of the bias in the CPI are Distortion of private agreements Increases in government outlays Distortion of Private Agreements Many private agreements, such as wage contracts, are linked to the CPI. If the CPI is biased, these agreements might deliver an outcome different from that intended by the parties.

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**7.2 THE CPI AND THE COST OF LIVING**

Suppose that the UAW and GM sign a 3 year wage deal: In the first year, the wage will be $30 an hour and will rise by the inflation rate in the next two years. If the inflation rate is 5 percent a year, the wage rises to $31.50 an hour in the second year and $33.08 an hour in the third year. But if the actual inflation rate is 2 percent a year, the intended wages in the second and third year are $30.90 an hour and $31.83 an hour. The workers’ gain is GM’s loss. With thousands of workers, GM’s loss would be millions of dollars over the 3 years.

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**7.2 THE CPI AND THE COST OF LIVING**

Increases in Government Outlays Close to a third of federal government outlays are linked directly to the CPI. The CPI is used to adjust 48 million Social Security benefit payments 22 million food stamp payments 4 million pensions for retired military personnel, federal civil servants, and their surviving spouses the budget for 27 million school lunches

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**7.2 THE CPI AND THE COST OF LIVING**

The GDP Deflator: A Better Measure? In principle, the GDP deflator is not subject to the biases of the CPI because it uses the basket of goods and services produced in the current year and the preceding year. In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not directly measure the physical quantities of all the goods and services that are produced.

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**7.2 THE CPI AND THE COST OF LIVING**

Instead, to estimate quantities, the Commerce Department divides expenditures by price indexes. And one of these price indexes is the CPI. So the biased CPI injects a bias into the GDP deflator.

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**7.2 THE CPI AND THE COST OF LIVING**

Figure 7.3 shows the two measures of inflation in part (a) and the corresponding two measures of the price level in part (b).

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**7.2 THE CPI AND THE COST OF LIVING**

The two measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure. But the price levels get farther apart. Both measures probably overstate the inflation rate.

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**7.3 NOMINAL AND REAL VALUES**

Dollars and Cents at Different Dates To compare dollar amounts at different dates, we need to know the CPI at those dates. Convert the price of a 2-cent stamp in 1905 into its 2005 equivalent: Price of stamp in 2005 dollars = Spend time helping students appreciate the distinction between real values and nominal values. Price of stamp in 1905 dollars x CPI in 2005 CPI in 1905 = 2 cents x 195.6 9.4 = 42 cents

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**7.3 NOMINAL AND REAL VALUES**

Nominal and Real Values in Macroeconomics Macroeconomics makes a big issue of the distinction between nominal values and real values: Nominal GDP and real GDP Nominal wage rate and real wage rate Nominal interest rate and real interest rate We studied the distinction between and calculation of nominal and real GDP in Chapter 20. Here, we’ll look at the other two.

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**7.3 NOMINAL AND REAL VALUES**

Nominal and Real Wage Rates Nominal wage rate The average hourly wage rate measured in current dollars. Real wage rate The average hourly wage rate measured in the dollars of a given reference base year. Use the US President example to emphasize the difficulty of holding relevant factors constant to calculate a real wage.

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**7.3 NOMINAL AND REAL VALUES**

To calculate the real wage rate, we divide the nominal wage rate by the CPI and multiply by 100. That is, Nominal wage rate in 2002 CPI in 2002 x 100 Real wage rate in 2002 = Real wage rate in June 2002 = = $8.16 $14.68 179.9 x 100 The $8.16 amount is in 19821984 dollars.

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**7.3 NOMINAL AND REAL VALUES**

Figure 7.4 shows nominal and real wage rates: 1975–2005. The nominal wage rate has increased every year since 1975. The real wage rate increased briefly during the late 1970s, decreased through the mid-1990s, and then increased slightly.

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**7.3 NOMINAL AND REAL VALUES**

Nominal and Real Interest Rates Nominal interest rate The percentage return on a loan expressed in dollars. Real interest rate The percentage return on a loan, calculated by purchasing power—the nominal interest rate adjusted for the effects of inflation. Real interest rate = Nominal interest rate – Inflation rate

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**7.3 NOMINAL AND REAL VALUES**

Figure 7.5 shows real and nominal interest rates: 1965–2005. During the 1970s, the real interest rate became negative. The nominal interest rate increased during the high-inflation 1980s.

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The CPI in YOUR Life Think about your student loan—or if you don’t have one, think about Gus’s $80,000 loan. Suppose that the CPI rises by 3 percent a year, each year from now through 2025. How much will a $100 repayment cost you, in 2005 dollars, when you start to pay off your loan in 2015? How much will a $100 repayment cost you, in 2005 dollars, when you make your final payment in 2025? What is the real interest rate that you will have paid? Would you be better off or worse off if the CPI began to rise at 5 percent a year?

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