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# Chapter 6 Measuring the Cost of Living.docx

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Ryerson University

Economics

ECN 204

Paul Missios

Winter

Description

Chapter 6 Measuring the Cost of Living
Consumer Price Index: a measure of the overall cost of the goods and services bought by a typical
customer (Stats Canada computes this every month)
How the CPI is calculated
1) Determine the basket: determine which prices are most important to the typical customer.
Stats Canada usually surveys consumers (example, more people buy hot dogs than hamburgers)
2) Find the prices: find the prices of each of the goods and services in the basket for each point in
time. (different months, years)
3) Compute the basket’s cost: compute the cost by multiplying the price of the good/service and
the quantity for each year
4) Choose a Base year and compute the index: designate one year as the base year
Calculation:
CPI = Price of basket of goods in Current year/Price of basket in Base year x 100
5) Compute the Inflation rate: use the CPI to calculate the inflate rate which is the percentage
change in the price index from the preceding period
Calculation:
Inflation Rate in year 2= CPI in year 2 – CPI in year 1/CPI in year 1 x 100
Core Inflation: the measure of the underlying trend of inflation
Example 1:
Activity #1
Question 1: Compute the CPI in 2009
Answer:
Cost of CPI basket in 2009 = ($5 x 10) + ($5 x 20) = $150
CPI in 2009= 100 x ($150/$120) = 125Question 2: What was the CPI inflation rate from 2009-2010?
Answer:
Cost of CPI basket in 2010 = ($9 x 10) + ($6 x 20) = $210
CPI in 2010= 100 x ($210/$120) = 175
CPI inflation rate = (175-125)/125 = 40%
Problems in Measuring the Cost of living
1: Commodity Substitution Bias
-When prices change from one year to the next, they do change proportionately. Some prices rise more
than others. Consumers substitute towards goods that have become relatively less expensive. If a CPI is
computed assuming a fixed basket, it ignores the possibility of consumer substitution and overstates the
increase in the cost of living from one year to the next
2: Introduction of New Goods
-When a new good is introduced, consumers have more variety from which to choose. Greater variety
makes each dollar more valuable so consumers need fewer dollars to maintain any standard of living.
Because the CPI is based on a fixed basket, it does not reflect the increase in the value of the dollar the
arises from the introduction of new goods and overstates increase in cost of living
3: Unmeasured Quality of Change
-If the quality of good deteriorates from one year to the next, the value of a dollar falls, even if the price
of the good stays the same. If the quality rises from one year to the next, the dollar rises. Changes in
quality remain a problem because quality is so hard to measure and overstates cost of living
Activity #2
Household Basket in 2010: 5# beef, 25# chicken
Question 1: Compute cost of the 2010 household basket
Answer: ($9 x 5) + ($6 x 25) = $195
Question 2: Compute % increase in cost of household basket over 2009-10, compare to CPI inflation
rate
Answer:
Rate of increase: ($195 - $150)/$150 = 30%
CPI inflation rate from previous problem = 40%The GDP Deflator versus The Consumer Price I

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