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Chapter 6

Measuring the Cost of Living - Chapter 6.docx

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York University
ECON 1010
Frank Miller

Measuring the Cost of Living The CPI - Used to monitor changes in cost of living over time - When CPI rises, typical family has to spend more to maintain same standard of living - Inflation: situation in which economy’s overall price levels is rising - Inflation rate: percent change in price level from previous periods Calculating the CPI - CPI is a measure of the overall cost of goods/services bought by a typical consumer 1) Determine the basket: need to determine which prices are most important to the consumer; greater the importance, greater the weight assigned - need to create a basket of goods and services that consumers buy 2) Find the prices: find the price of each of the goods/services for each point in time 3) Compute the basket’s cost: calculate the cost of the basket of goods/services at different times; only the prices change the basket of goods are the same - We isolate price changes from effect of quantity change that might be occurring 4) Choose a base year and compute the index: designate one year as the base year; it is the benchmark against which other years are compared 5) Compute the inflation rate: calculate inflation rate between two consecutive years - Inflation rate in Year 2 = ((CPI Year 2 – CPI Year 1)/CPI Year1) x 100 - CPI = (price of basket of goods/services in current year / price of basket in base year) x 100 - Core inflation: measure of the underlying trend of inflation Problems in Measuring the CPI - CPI tries to gauge how much incomes must rise to maintain constant standard of living 1) Commodity substitution bias: prices do not change proportionately from one year to the next; some rise more than others - Consumers buy less of goods/services whose price have risen and more of those whose prices have fallen - Assuming fixed basket of goods, CPI ignores possibility of consumer substitution, and overstates increase in cost of living from one year to the next - Fixed basket assumes that consumers continue to buy the “now” expensive products in same quantities as before 2) Introduction of new goods: when new goods/services come in the market, consumers have more variety, makes each dollar more valuable - Consumers then need fewer dollars to maintain any given standard of living - CPI does not reflect increase in value of the dollar that arises from introduction of new goods 3) Unmeasured quality change: if quality deteriorates value of a dollar falls even if the price of the good stays the same - Essential to account for quality change compute price of a basket of goods of constant quality - CPI suggests that adjustments to wages, pensions and social payments may be larger than necessary to maintain purchasing power of these wages and benefits GDP Deflator vs. the CPI - Nominal GDP: current output valued at current prices - Real GDP: current output valued at base year price - GDP Deflator: reflects current level of prices relative to level of price in base year - The difference between the two measures: 1) GDP Deflator reflects prices of all goods and services produced domestically; CPI reflects prices of all goods/services bought by
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