Measuring the Cost of Living

The Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a key economic indicator that measures the typical consumer’s cost of living. It tracks changes in the price level of a market basket of consumer goods and services purchased by households over time.

• Definition: CPI quantifies the average change in prices paid by urban consumers for a fixed basket of goods and services.

• Purpose: Used to assess price changes associated with the cost of living and to adjust income payments (such as Social Security).

How the CPI Is Calculated

The calculation of the CPI involves several systematic steps to ensure accuracy and consistency.

• Fix the “basket”: The Bureau of Labor Statistics (BLS) surveys consumers to determine the composition of a typical consumer’s “shopping basket.”

• Find the prices: The BLS collects data on the prices of all the goods and services in the basket.

• Compute the basket’s cost: The prices are used to compute the total cost of the basket for each period.

• Choose a base year and compute the index: The CPI in any year is calculated as:

• Compute the inflation rate: The percentage change in the CPI from the preceding period is the inflation rate:

Example: Calculating the CPI

Suppose the basket contains 10 lbs. of beef and 20 lbs. of chicken. The following table shows the prices over three years:

• Step 1: Compute the cost of the basket in each year.

• Step 2: Use the base year (2023) to calculate the CPI for 2024 and 2025.

• Step 3: Calculate the inflation rate between 2024 and 2025.

Example Calculation:

• Cost of basket in 2023:

• Cost of basket in 2024:

• CPI in 2024:

• Inflation rate from 2023 to 2024:

• Additional info: The actual numbers may vary based on the basket composition and prices.

What’s in the CPI’s Basket?

The CPI basket is composed of various categories of goods and services, reflecting typical consumer expenditures. The approximate shares are:

Problems with the CPI

Substitution Bias

Over time, some prices rise faster than others. Consumers tend to substitute toward goods that become relatively cheaper, which mitigates the effect of price increases. However, the CPI uses a fixed basket and does not account for this substitution, causing it to overstate the true increase in the cost of living.

• Definition: Substitution bias occurs when consumers change their purchasing habits in response to relative price changes, but the CPI does not reflect these changes.

• Example: If beef becomes more expensive than chicken, consumers may buy more chicken, but the CPI basket remains unchanged.

Introduction of New Goods

The introduction of new goods increases consumer choice and allows consumers to find products that better meet their needs. This makes each dollar more valuable, but the CPI misses this effect because it uses a fixed basket of goods over time, thus overstating the true increase in the cost of living.

• Example: The arrival of smartphones improved consumer welfare, but the CPI did not immediately account for this new product.

Unmeasured Quality Change

Improvements in the quality of goods and services increase the value of each dollar spent. The BLS attempts to account for quality changes, but some improvements are difficult to measure, leading the CPI to overstate the true increase in the cost of living.

• Example: Advances in medical care or technology may not be fully captured in the CPI.

Contrasting the CPI and GDP Deflator

Differences Between CPI and GDP Deflator

The CPI and GDP deflator are both measures of inflation, but they differ in coverage and calculation.

• Example: A price increase in imported jeans affects the CPI but not the GDP deflator.

Correcting Variables for Inflation

Comparing Dollar Figures from Different Times

Inflation makes it difficult to compare dollar amounts from different periods. To compare, use the CPI to convert past figures into "today's dollars." The formula is:

• Example: Minimum wage in 1964 was $1.15, CPI in 1964 was 31.0, CPI in 2024 is 313.7.

• Minimum wage in 2024 dollars:

Real vs. Nominal Interest Rates

Interest rates can be expressed in nominal or real terms. The nominal interest rate is not corrected for inflation, while the real interest rate is adjusted for inflation and reflects the growth in purchasing power.

• Formula:

• Example: Deposit .

• The purchasing power of the deposit grows by 5.5%.

Summary Table: Key CPI Concepts

Additional info: These notes expand on the original slides and text, providing full definitions, formulas, and examples for clarity and completeness.