Chapter 25 - The cost of living. After studying this chapter you will be able to understand: What a market basket is and why it’s important? How to calculate and use a price index? How to identify challenges the Bureau of Labor Statistics (BLS) faces when measuring inflation? How the BLS responds to these challenges?...
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Chapter 25
The Cost of Living
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• What a market basket is and why it’s important
• How to calculate and use a price index
• How to identify challenges the Bureau of Labor
Statistics (BLS) faces when measuring inflation
• How the BLS responds to these challenges
• How to calculate the inflation rate using three
methods
• How to adjust nominal values into real values
• How to define and calculate purchasing power
parity
What will you learn in this chapter?
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impact how much we can buy
and place
incentives and choices
– Price levels determine the relative value of salaries,
savings and borrowing, and the relative cost of
living in a different city.
The cost of living
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the cost of living across time and place
services in fixed quantities
– The goal is to use this to see how the cost of
buying these goods and services changes over time
and location.
– Items typically purchased by individuals.
– Keeping the quantities of each item constant
ensures that changes only reflect price changes.
The market basket
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• Consider changes in the prices of four items you
typically buy at the grocery store.
• How much did the cost of groceries rise between years?
The market basket
Quantity purchased Price last year ($) Price this year ($)
Carrots (per pound) 1 1.00 1.25
Total Cost 2012 = ($3.00 x 1)+($2.50 x 1)+($3.50 x 3)+($1.00 x 1)= $17.00
Total Cost2013= ($3.15 x 1)+($2.55 x 1)+($3.64 x 3)+($1.25 x 1) = $17.87
Price increase from 2012 to 2013 = [($17.87 - $17)/$17] x 100 = 5.1%
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Information for the market basket is listed in the table.
Calculate the total cost for each year.
Active Learning: Calculating total cost
Year Quantity of Apples Quantity of Oranges Price of Apples ($) Price of Oranges($)
2012
2013
2014
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• A price indexis a measure showing how much the
cost of a market basket has changed relative to
the cost in a base time period or location
– Base year index is equalized to 100.
• The Consumer Price Index (CPI) is a measure that
tracks changes in the cost of a basket of goods
and services purchased by a typical U.S
household
– CPI is the most commonly used index tool for tracking
changes in the cost of living in the U.S.
– The CPI is tracked by the Bureau of Labor Statistics
(BLS).
Consumer price index
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• The CPI measures the increase in the cost of the market
basket relative to the cost in a given base year.
CPI = × 100
• By definition, the index always equals 100 in the base
year.
– The index will be greater than 100 if the cost of the basket
is greater than the base-year cost.
– The index will be less than 100 if the cost of the basket is
less than the base-year cost.
Consumer price index
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Information on total cost for each year is listed in the table.
Calculate the CPI for the basket of goods in each year assuming
that the base year is 2012.
Active Learning: Calculating CPI
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The following illustrates the CPI from 1913 to 2011
Consumer price index
0
50
100
150
200
250
Consumer price index
(1984 = 100)
CPI
Year
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• There are two main challenges
• Which goods should be included in the market
basket?
– A single number cannot perfectly describe changes in
the cost of living for everyone.
• The BLS tries to come up with a basket that
represents a “typical” household
– The CPI basket is based on the average goods and
services purchased by “urban consumers.”
– One family’s cost of living could be different than that
computed by the CPI depends on what they
purchase.
The challenges in measuring price changes
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• The chart below provides a snapshot of the
current CPI’s basket
• Represents spending by urban consumers
The challenges in measuring price changes
4%
4%
6%
6%
7%
15%
17%
41%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Other goods and services
Apparel
Recreation
Education and communication
Medical care
Food and beverage
Transportation
Housing
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goods remains fixed even if consumers
substitute between similar goods
– If the relative price of goods changes, the
quantities change as well.
– As new goods and services become available
(innovation), people will adjust what they
consume.
constant, which does not account for
consumption changes
The challenges in measuring price changes
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• Similar to GDP, economic variables give
an incomplete picture when expressed in
nominal terms, as their real value may be
different over time.
• Price indices transform nominal values
into real values
other economic variables, like income and
output
Using price indices
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in the overall price level.
• It is calculated as the percentage change
in the CPI from year to year:
The inflation rate
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The following table calculates the inflation rate
The inflation rate
• The CPI tells how much prices have changed from the base year prices
(1984).
• The inflation rate tells by how much prices have changed from year to
year.
• In 2009 the inflation rate was negative; deflationoccurred.
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Calculate the inflation rates for 2013 and 2014
using the following information
Active Learning: Calculating inflation rates
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– Headline inflation measures price changes for the entire
market basket.
energy costs removed.
• Energy and food prices fluctuate often, which could
over- or understate the real change in overall prices.
• Producer price index (PPI) measures the prices of
goods and services purchased by firms
• GDP deflator measures the prices of goods and
services produced in the country
The inflation rate
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This graph provides the three common measures of
inflation for the United States from 1960-2010
The inflation rate
-10
-5
0
5
10
15
20
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Consumer price index GDP deflator Producer price index Percent change
Year
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“deflate” nominal values into real values
– Compares purchasing power over time
year Y value using:
Real value = Nominal value ×CPI
CPI
Deflating nominal variables
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This table provides the value of the top 20% earners for
the last five decades in terms of the year 2000 prices.
Deflating nominal variables
36.7 =
72.6 =
X 214.5 =
X 214.5 =
$135,250
$ 85,529
$ 43,265
$ 20,520
$174,136
$147,951
$127,828
$119, 933
1999 135,250
124.0
CPI
(1982 – 84 = 100)
166.6 85,529
1989
• The average income of those living in 1969 looks much lower than in
2000.
• Inflating 1969 nominal incomes to the year 2000 prices, the value of
a dollar in each year is the same between the two decades The gap
decreases dramatically.
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Suppose a worker made $4.25/hour in 1993
How much is this worth today if the CPI in 1993
was 142 and today it is 216?
Active Learning: Deflating nominal variables
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the effects of inflation
– However, there are times when some prices
change faster than wages.
increasing payments in proportion to the cost
of living
– These payments are often referred to as
“cost-of-living adjustments.”
Adjusting for inflation: Indexing
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While minimum wage has increased over time, the real
value of minimum wage has fallen since the late 60s.
Adjusting for inflation: Minimum wage
Minimum wage Real wage
0
2
4
6
8
10
12
1938 1944 195 195 196 196 197 198 198 199 199 200 2010
Dollars
• The nominal minimum wage has steadily increased since the 1940s
• The real value has fluctuated as Congress has adjusted the nominal value to try to keep up with inflation
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countries should be the same when stated in a
common currency
three main factors:
Accounting for price differences across places
Trade restrictions
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to creating a price index:
1 Find a market basket of foods and services to
compare across countries.
2 Measure the price of the goods in each country.
3 Calculate the cost of purchasing the basket in
each country.
4 Build an index showing how much the basket
costs in each country relative to some base.
Purchasing power indexes
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One example of a PPI is the Big Mac Index
• Uses McDonald’s Big Mac as the basket.
• Compares the price of a Big Mac in each country to the
U.S.
Purchasing power indexes
China Thailand
Malaysia
Russia
Mexico
South Africa
South Korea Singapore Britain Japan
Canada Euro area Brazil Switzerland
Percent by which local currency is valued relative to the dollar
3.82 3.19
2.45 2.55
2.34 2.46 2.44
4.63 6.81
Big Mac price in $
Cost of living is higher than U.S.
(Lower purchasing power of local
currency per nominal dollar)
Cost of living is lower than U.S.
(Higher purchasing power of local
currency per nominal dollar)
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levels across countries
countries:
PPI– adjusted GDP =
Nominal dollars × [ ( )]
difference in purchasing power between the
two countries
PPP-adjustment
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Suppose Argentina has a GDP per capita of
$10,942 USD and that the cost of living is 30.2%
lower than the United States What is the
PPI-adjusted GDP for Argentina?
Active Learning: Calculating PPI-adjusted GDP
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how the overall cost of living has changed over
time
– Holding goods and quantities constant isolates
price changes.
summarize changes in price levels
CPI
Summary
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in the overall price level between years
purchasing power of money from different
time periods
price levels in different countries should be the
same once they are stated in a common
currency
Summary
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transaction costs, non-tradables, and trade
restrictions
items to include in the basket and how to
adjust for changes in consumption over time
price index to account for differences in
purchasing power across countries
Summary