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%eventh &dition
Macroeconomics
Principles of
N. Gregory Mankiw
CHAPTER
11
Measuring the
Cost of Living
W
ojciechGerson(1831-1
901)
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In this chapter,
look for the answers to these questions
What is the Consumer Price Index (CPI)?How is it calculated? Whats it used for?
What are the pro!lems with the CPI? Howserious are the"?
How does the CPI differ from the #$P deflator?
How can we use the CPI to compare dollaramounts from different "ears? Wh" would wewant to do this, an"wa"?
How can we correct interest rates for inflation?
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3
%he Consumer Price Index (CPI)
measures the t"pical consumers cost of li&in' the !asis of cost of li&in' adustments (C*+s)
in man" contracts and in ocial ecurit"
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4
How the CPI Is Calculated
1. Fix the basket.%he -ureau of *a!or tatistics (-*) sur&e"sconsumers to determine whats in the t"picalconsumers .shoppin' !asket/0
2. Find the prices.
%he -* collects data on the prices of all the'oods in the !asket/
3. Compute the baskets cost.1se the prices to compute the total cost of the!asket/
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5
How the CPI Is Calculated4. Choose a base year and compute the index.
%he CPI in an" "ear equals
5. Compute the infation rate.
%he percenta'e chan'e in the CPI from the
precedin' period/
233 xcost of !asket in current "ear
cost of !asket in !ase "ear
CPI this "ear4 CPI last "ear
CPI last "ear
Inflation
ratex23356
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78+9P*7 !asket: ;< pi==as, 23 lattes>
2@ x < A B x 23 6 D
22 x < A @/E x 23 6 FG
23 x < A @ x 23 6 F3
cost of basket
B/33
@/E3
@/33
price of
latte
2@@32@
22@322
23@323
price of
pizzayear
Compute CPI in each "ear
@323: 233 x (F3F3) 6 233
@322: 233 x (FGF3) 6 22E
@32@: 233 x (DF3) 6 2B3
Inflation rate:
2E5
22E4233
233 x23356
2B52B3422E
22Ex23356
usin' @323 !ase "ear:
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A C T I V E L E A ! I ! G 1
Calculate the CPI
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CPI !asket:;23 l!s !eef,
@3 l!s chicken>
%he CPI !asket cost 2@3
in @323, the !ase "ear/
A. Compute the CPI in @322/
B. What was the CPI inflation rate from @3224@32@?
price
of beef
price of
chicken
@323 <
In @323 and @322,
households!ou'ht CPI !asket/
In @32@, households !ou'ht ;E l!s !eef, @E l!s chicken>/
beef chicken cost of CPIbasket
@323 < < 2@3
@322 E E 2E3@32@ G F @23
A. Compute cost of the @32@ household !asket/
B. Compute 5 increase in cost of household !asket
o&er @32242@, compare to CPI inflation rate/
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A C T I V E L E A ! I ! G "
+nswers
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A. Compute cost of the @32@ household !asket/(G x E) A (F x @E) 6 2GE
CPI !asket: ;23 l!s !eef,
@3 l!s chicken>
Household
!asket in @32@: ;E l!s !eef,
@E l!s chicken>
beef chicken cost of CPIbasket
@323 < < 2@3
@322 E E 2E3@32@ G F @23
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A C T I V E L E A ! I ! G "
+nswers
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B. Compute 5 increase in cost of household !asketo&er @32242@, compare to CPI inflation rate/
Jate of increase: (2GE 4 2E3)2E3 6 B35
CPI inflation rate from pre&ious pro!lem 6
Household
!asket in @32@: ;E l!s !eef,
@E l!s chicken>
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$4
Pro!lems with the CPI:Substitution Bias
&er time, some prices rise faster than others/
Consumers su!stitute toward 'oods that !ecomerelati&el" cheaper, miti'atin' the effects of price
increases/ %he CPI misses this su!stitution !ecause it uses
a fixed !asket of 'oods/
%hus, the CPI o&erstates increases in the cost ofli&in'/
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$5
Pro!lems with the CPI:Introduction of New Goods
%he introduction of new 'oods increases &ariet",allows consumers to find products that moreclosel" meet their needs/
In effect, dollars !ecome more &alua!le/
%he CPI misses this effect !ecause it uses afixed !asket of 'oods/
%hus, the CPI o&erstates increases in the cost ofli&in'/
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$
Pro!lems with the CPI:Unmeasured Quality Chane
Impro&ements in the qualit" of 'oods in the!asket increase the &alue of each dollar/
%he -* tries to account for qualit" chan'es
!ut pro!a!l" misses some, as qualit" is hard tomeasure/
%hus, the CPI o&erstates increases in the cost ofli&in'/
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$!
Pro!lems with the CPI
7ach of these pro!lems causes the CPI to
o&erstate cost of li&in' increases/
%he -* has made technical adustments,!ut the CPI pro!a!l" still o&erstates inflation
!" a!out 3/E percent per "ear/ %his is important !ecause ocial ecurit"
pa"ments and man" contracts ha&e C*+s tiedto the CPI/
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$"
2GF3 2GFE 2G3 2GE 2GD3 2GDE 2GG3 2GGE @333 @33E @323KE
3
E
23
2E
GDP deflator CPI
%wo 9easures of Inflation, 2GF34@32B
Percentchange
peryear
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$#
Imported consumer 'oods:
included in CPI excluded from #$P deflator
%he !asket:
CPI uses fixed !asket #$P deflator uses !asket of
currentl" produced 'oods L ser&ices
%his matters if different prices are
chan'in' !" different amounts/
Capital 'oods:
excluded from CPI included in #$P deflator
(if produced domesticall")
Contrastin' the CPI and #$P $eflator
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A C T I V E L E A ! I ! G 3
CPI &s/ #$P deflator
In each scenario, determine the effects on theCPI and the #$P deflator/
A. tar!ucks raises the price of rappuccinos/
B. Caterpillar raises the price of the industrialtractors it manufactures at its Illinois factor"/
C. +rmani raises the price of the Italian eans it
sells in the 1//
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A C T I V E L E A ! I ! G 3
+nswers
A. tar!ucks raises the price of rappuccinos/!he C"# and $%" defator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factor"/!he $%" defator rises& the C"# does not.
C.+rmani raises the price of the Italian eans it
sells in the 1//!he C"# rises& the $%" defator does not.
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22
Correctin' Maria!les for Inflation:
Comparin' $ollar i'ures from $ifferent %imes
Inflation makes it harder to compare dollaramounts from different times/
7xample: the minimum wa'e
2/@E in $ec 2GFB
/@E in $ec @32B
$id min wa'e ha&e more purchasin' power in$ec 2GFB or $ec @32B?
%o compare, use CPI to con&ert 2GFB fi'ure into.@32B dollars0N
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23
In our example,
."ear !0 is 2@2GFB, .toda"0 is 2@@32B
9in wa'e was 2/@E in "ear !
CPI 6 B3/G in "ear !, CPI 6 @B
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24
Correctin' Maria!les for Inflation:
Comparin' $ollar i'ures from $ifferent %imes
Jesearchers, !usiness anal"sts, and polic"makersoften use this technique to con&ert a time series ofcurrentKdollar (nominal) fi'ures into constantKdollar(real) fi'ures/
%he" can then see how a &aria!le has chan'edo&er time after correctin' for inflation/
7xample: the minimum wa'eN
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2GF32GFE2G32GE2GD32GDE2GG32GGE@333@33E@3233
@