The CPI and the Cost of Living

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Which movie really was

the biggest box office hit?

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16When you have completed your study of this chapter, you will be able to

1 Explain what the Consumer Price Index (CPI) is and how it is calculated.

2 Explain the limitations of the CPI and describe other measures of the price level.

3 Adjust money values for inflation and calculate real wage rates and real interest rates.

CHAPTER CHECKLIST

The CPI and the Cost of Living

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16.1 THE CONSUMER PRICE INDEX

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

The BLS calculates the CPI every month.

We can use these numbers to compare what a fixed basket of goods costs this month with what it cost in some previous month.

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Reading the CPI Numbers

The CPI is defined to equal 100 for a period called the reference base period.

Reference base period is a period for which the CPI is defined to equal 100.

Currently, the reference base period is 19821984.

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In May 2013, the CPI was 232.9.

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services was 132.9 percent higher in May 2013 than it was on the average during 19821984.

In April 2013, the CPI was 232.5

The average of the prices paid by urban consumers for a fixed market basket of consumer goods and services increased by 0.4 percentage points in May 2013.

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Constructing the CPI

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

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The CPI Market Basket

The relative importance of the items in the CPI basket is 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 CPI basket in 2013 is based on information obtained from the Consumer Expenditure Survey conducted during 2011.

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Figure 16.1 shows the CPI basket in May 2013.

This shopping cart is filled with the items that an average household buys.

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The Monthly Price Survey

Each month, BLS employees check the prices of the 80,000 goods and services in the eight large groups shown 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.

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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.

Table 16.1 on the next slide shows a simplified CPI calculation in which we assume a base period of 2010.

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CPI = Cost of CPI basket at current period pricesCost of CPI basket at base period prices

x 100

For 2010, the CPI is: = 100$50

$50x 100

For 2014, the CPI is: = 140$70

$50x 100

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Measuring Inflation and Deflation

Inflation rate is the percentage change in the price level from one year to the next.

Inflation rate = = 16.7 percent140 120

120x 100

CPI in current year CPI in previous year

CPI in previous year x 100Inflation rate =

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Deflation is a situation in which the inflation rate is negative.

For example, in July 2009 the CPI was 215.4, and in July 2008 it was 220.0.

So during that year,

Inflation rate = = 2.1 percent.215.4 220.0

220.0x 100

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Figure 16.2 shows the CPI in part (a) and the inflation rate in part (b).

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1. The price level was rising rapidly in the 1980s and the inflation rate was high.

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2. The price level was rising slowly during the 1990s and 2000s and the inflation rate was low.

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3. In 2009, the price level fell and the inflation rate was negative.

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16.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Cost of living index is 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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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


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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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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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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 increased the frequency of its Consumer Expenditure Survey and revises the CPI basket every two years.

When the BLS revises the CPI basket, the reference base period does not change.


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Two Consequences of the CPI Bias

Two main consequences of the bias in the CPI are• Distortion of private contracts• Increases in government outlays and decreases in

taxes

Distortion of Private Contracts

Many wage contracts are linked to the CPI.

If the CPI is biased, these contracts might deliver an outcome different from that intended by the parties.


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Suppose that the UAW and Ford 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 years are $30.90 an hour and $31.83 an hour.

The workers’ gain is Ford’s loss. With thousands of workers, Ford’s loss is millions of dollars over the 3 years.


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Increases in Government Outlays and Decreases in Taxes

Close to a third of federal government outlays are linked directly to the CPI.

The CPI is used to adjust:• 55 million Social Security benefit payments • 45 million food stamp payments• 4 million pensions for retired military personnel,

federal civil servants, and their surviving spouses • The budget for 3 million school lunches


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The CPI is used to adjust the income levels at which higher tax rates apply.

Tax rates on large incomes are higher than those on small incomes, so as incomes rise the burden of taxes would rise relentlessly if these adjustments were not made.

To the extent that the CPI is biased upward, the tax adjustments overcompensate for rising prices and decrease the amount paid in taxes.


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Alternative Measures of the Price Level and Inflation Rate

Several alternative measures of the price level are available.

Here we look at

• GDP price index

• Personal consumption expenditures (PCE) price index

• PCE price index excluding food and energy


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GDP Price Index

The GDP price index is an average of current prices of all the goods and services included in GDP expressed as a percentage of base-year prices.

GDP price index = (Nominal GDP Real GDP) 100.

The GDP price index is a measure of the price level.

The percentage change in the GDP price index is a measure of the inflation rate.


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Two differences between the GDP price index and the CPI result in different estimates of the price level and inflation rate.

1. The GDP price index uses the prices of all the goods and services in GDP.

The CPI uses prices of consumption goods and services.

2. The GDP price index weights each item using information about current as well as past quantities.

In contrast, the CPI weights each item using information from a past Consumer Expenditure Survey.


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Because the GDP price index uses information on current year quantities, it includes new goods and quality improvements and even allows for substitution effects of both commodities and retail outlets.

So in principle, the GDP price index is not subject to the biases of the CPI.


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PCE Price Index

The PCE price index is an average of current prices of all the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices.

The PCE price index, like the GDP price index, uses current information on quantities and prices and to some degree overcomes the sources of bias in the CPI.

Because it focuses on consumption expenditure, it a possible measure of the cost of living.


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PCE Price Index Excluding Food and Energy

Food and energy prices fluctuate much more than other prices, so their changes can obscure the underlying trends in prices.

By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly.

The percentage change in the PCE price index excluding food and energy is called the core inflation rate.


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16.2 THE CPI AND OTHER PRICE LEVEL …

Figure 16.3 shows the three measures of the price level and their inflation rates.

The three measures of the price level move together.

But the CPI increases more quickly than the two PCE measures.

The path of the CPI shows the bias in the CPI as a measure of the price level.

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The three measures of the inflation rate fluctuate together.

But the core inflation rate fluctuates less than the other two measures.

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16.3 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¢ stamp in 1913 into its 2013 equivalent:

Price of stamp in 2013 dollars =

= 2¢ x

232.1

9.9= 46.9 cents

Price of stamp in 1913 dollars xCPI in 2013

CPI in 1913

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Alternatively, we could convert the 46¢ stamp in 2013 into its 1913 equivalent by calculating the real price of the 2013 stamp in 1913.

Price of stamp in 1913 dollars =

=46¢ x

9.9

232.1= 1.96 cents.

Price of stamp in 2013 dollars xCPI in 1913

CPI in 2013

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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 the calculation of nominal and real GDP in Chapter 21. Here we’ll look at the other two.

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Nominal Wage Rate and Real Wage Rate

Nominal wage rate is the average hourly wage rate measured in current dollars.

Real wage rate is the average hourly wage rate measured in the dollars of a given reference base year.

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Real wage rate in 2013 = = $8.66$20.10

232.1x 100

To calculate the real hourly wage rate, we divide the nominal hourly wage rate by the CPI and multiply by 100. That is,

Nominal wage rate in 2013

CPI in 2013x 100Real wage rate in 2013 =

The $8.66 an hour is in 19821984 dollars.

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Figure 16.4 shows nominal and real wage rates: 1980 to 2013.

despite the increase in the nominal wage rate every year.

Since 1980, the real wage rate barely changed, …

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Nominal Interest Rate and Real Interest Rate

Nominal interest rate is the dollar amount of interest expressed as a percentage of the amount loaned.

Real interest rate is the goods and services forgone in interest expressed as a percentage of the amount loaned.

Real interest rate = Nominal interest rate – Inflation rate.

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Figure 16.5 shows real and nominal interest rates: 1973 to 2013.

The gap between the nominal interest rate and the real interest rate equals the inflation rate.

The real interest rate is usually positive, but during the 1970s it became negative.

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Gone with the Wind is the answer.

To get this answer, Box-Office Mojo calculates the amount that a movie really earns.

Box-Office Mojo converts the dollars earned to their equivalent in current year dollars.

But rather than use the CPI, it uses the average prices of movie tickets as its price index.

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Gone with the Wind was made in 1939 and rereleased in nine subsequent years.

By 2012, it had earned a total box office revenue of almost $200 million in the United States.

The Avengers, released in 2012, earned $623 million.

The Avengers earned more than 3 times the dollars earned by Gone with the Wind.

Which movie really earned more box office revenue?

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To convert the Gone with the Wind revenues into 2012 dollars, …

multiply the dollars received each year by the 2012 CPI and divide by the CPI for the year in which the dollars were earned.

Box-Office Mojo has done such a calculation, but rather than use the CPI, it used the average prices of movie tickets.

According to Box-Office Mojo, valuing the tickets for Gone with the Wind at 2012 movie-ticket prices, it has earned $1,604 million, about 2.6 times The Avengers’ revenue.

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Because Box-Office Mojo uses average ticket prices, the real variable that it compares is the number of tickets sold.

The average ticket price in 2012 was $7.96, so 202 million movie-goers have seen Gone with the Wind and 78 million have seen The Avengers.

Gone with the Wind was the biggest hit because it was seen by the greatest number of people.

Business

The CPI and the Cost of Living