Measuring the Cost of Living

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a key measure used to track changes in the cost of living over time. It reflects the average price level of a fixed basket of goods and services purchased by households.

• Purpose: To measure inflation and allow comparison of the purchasing power of money across different years.

• Calculation: The CPI is calculated by taking the cost of the basket in the current year, dividing it by the cost of the basket in the base year, and multiplying by 100.

• Interpretation: A rising CPI indicates inflation, while a falling CPI indicates deflation.

Example: If the CPI was 200 in 1980 and 300 today, then $600 in 1980 has the same purchasing power as $900 today.

Comparing CPI and GDP Deflator

• CPI vs. GDP Deflator: Both measure inflation but differ in scope and calculation.

• CPI: Focuses on consumer goods and services only.

• GDP Deflator: Measures the price of all goods and services produced domestically.

• Substitution Bias: The CPI can overstate inflation because it does not account for consumers substituting cheaper goods for more expensive ones.

Quick Quiz Example:

• The CPI measures approximately the same economic phenomenon as the GDP deflator.

• Because consumers can substitute cheaper goods, the CPI tends to overstate inflation.

Correcting Economic Variables for the Effects of Inflation

Purpose of Correction

Measuring the overall level of prices in the economy allows for meaningful comparison of dollar figures from different points in time.

Dollar Figures from Different Times

• To compare prices from different years, adjust for inflation using the CPI.

• Formula:

• Example Calculation: To convert 9.5 cents per litre in 1957 to 2025 dollars (assuming CPI in 2025 is 164.9 and in 1957 is 15.0):

cents ($1.04)

Bank of Canada's Inflation Calculator

• The Bank of Canada provides an online calculator to estimate the cost of a basket of goods in different years using the CPI.

• Application: Useful for understanding how inflation affects the value of money over time.

Indexation

Indexation is the automatic correction of a dollar amount for the effects of inflation by law or contract.

• Common in government transfer programs (e.g., Social Security, tax brackets).

• Also used in the private sector, such as in labour contracts with COST-OF-LIVING ALLOWANCES (COLA), which automatically adjust wages when the CPI rises.

Real and Nominal Interest Rates

Understanding Interest Rates

Interest rates compare amounts of money at different points in time. To assess the true gain in purchasing power, it is essential to correct for inflation.

• Nominal Interest Rate: The stated interest rate, not adjusted for inflation.

• Real Interest Rate: The interest rate adjusted for inflation, reflecting the true increase in purchasing power.

• Formula:

• Example: If you deposit $100 at 10% interest, after one year you have $110. If inflation is 5%, your real gain in purchasing power is 5%.

Case Study: Interest Rates in the Canadian Economy

Historical data shows that both nominal and real interest rates fluctuate over time, often diverging significantly during periods of high inflation.

• During the 1970s and early 1980s, high inflation led to lower real interest rates despite high nominal rates.

• In recent decades, both nominal and real rates have generally declined.

Practice Questions

Summary Table: Key Terms and Formulas

Additional info: The notes above expand on the slides by providing definitions, formulas, and examples for each concept, ensuring a self-contained and comprehensive study guide for macroeconomics students.