ECON 1 Lecture Notes - Lecture 13: Gdp Deflator, Interest Rate, Nominal Interest RatePremium
Course CodeECON 1
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ECON 1 - Lecture 13 - Measuring the Cost of Living
Look for the answers to these questions
● What is the Consumer Price Index (CPI)?
○ How is it calculated? What is it used for?
● What are the problems with the CPI? How serious are they?
● How does the CPI differ from the GDP deflator?
● How can we use the CPI to compare dollar amounts from different years? Why would we
want to do this anyway?
● How can we correct interest rates for inflation?
The Consumer Price Index
● Consumer price index (CPI)
○ Measure of the overall level of prices
○ Measure of the overall cost of goods and services
■ Brought by a typical consumer
● Computed and reported every month by the Bureau of Labor Statistics
1. Fix the basket
● The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in
the typical consumer’s “shopping basket”
2. Find the prices
● The BLS collects data on the prices of all the goods in the basket
3. Compute the basket’s cost
● Use the prices to compute the total cost of the basket
4. Chose a base year and compute the CPI
● Cost of basket of goods and services in current year divided by cost of basket in
● Times 100
5. Compute the inflation rate
● The percentage change in the CPI from the preceding period
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝐶𝑃𝐼 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟 − 𝐶𝑃𝐼 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
𝐶𝑃𝐼 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 ×100
Problems with the CPI
● Substitution Bias
○ Over time, some prices rise faster than others
○ Consumers substitute toward goods that become relatively cheaper, mitigating
the effects of price increases
○ The CPI misses this substitution because it uses a fixed basket of goods
○ Thus, the CPI overstates increases in the cost of living
● Introduction of New Goods
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