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Chapter 6 Measuring the Cost of Living.docx

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Ryerson University
ECN 204
Paul Missios

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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