Chapter 6 - Measuring the Cost of Living

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26 Apr 2012
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Wednesday January 25th, 2012
Chapter 6
Measuring the Cost of Living
The Consumer Price Index (CPI):
-Measures the typical consumer’s cost of living
-The basis of cost of living adjustments (COLAs) in many contracts and in Social Security
COLA = cost of living allowance
How the CPI Is Calculated:
1. Determine the “basket.”
Statistics Canada surveys consumers to determine what’s in the typical consumer’s “shopping
basket
2. Find the prices.
Statistics Canada collects data on the prices of all the goods in the basket
3. Compute the basket’s cost.
Use the data on prices to compute the total cost of the basket
4. Choose a base year and compute the index.
The CPI in any year equals
100 x cost of basket in current year / cost of basket in base year
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 x 100%
Problems with the CPI: Commodity Substitution Bias
-Over time, some prices rise faster than others
-Consumers substitute toward goods that become relatively cheaper
-The CPI misses this substitution because it uses a fixed basket of goods
-Thus, the CPI overstates increases in the cost of living
Problems with the CPI: Introduction of New Goods
-The introduction of new goods increases variety, allows consumers to find products that more closely
meet their needs.
-In effect, dollars become more valuable
Example: purchasing power
-The CPI misses this effect because it uses a fixed basket of goods
-Thus, the CPI overstates increases in the cost of living
Problems with the CPI: Unmeasured Quality Change
-Improvements in the quality of goods in the basket increase the value of each dollar
-Statistics Canada tries to account for quality changes but probably misses some, as quality is hard to
measure
-Thus, the CPI overstates increases in the cost of living
CPI is a real value!
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