Measuring the Costs of Living

Measuring the costs of living: Consumer price index (CPI) – measures the overall price level of goods and services bought by the typical consumer Index- does not have any units Computed and reported every month by the Bureau of Labor Statistics (government agency) Calculation of CPI: 1.) creation of basket of goods BLS estimates which prices are the most important to the typical consumer and assigns appropriate weights to prices of all goods in the basket 2.) it retrieves prices of those goods at a particular point in time during that month 3.) Computes the basket´s price, which changes every month 4.) Chooses a base year (CPI Base year = 100) CPI = Price of basket in current year / Price of basket in base year * 100 Inflation between Year 2 and Year 1 = CPI(2) – CPI(1) / CPI(1) *100% Inflation = rise in average prices over time Inflation rate = percentage change in price index from the preceding period Core CPI = measure of price level excluding food and energy – this is because food and energy prices are volatile Producer price index = measure of price cost of goods and services bought by the typical firm PPI is the leading indicator, which predicts a similar subsequent change in CPI because consumers buy from a buffer stock in inventory. An increase in producer price is not felt till inventory is depleted Typical expenditure shares for the US household: a) housing – 45% of expenditure b) transportation – 15% c) food – 12% Drawbacks of CPI: - Substitution bias- prices for all goods do not change at the same rate and consumers substitute towards the relatively cheaper product. This is not reflected by the CPI which relies on the same basket of goods. Therefore, the CPI often overstates inflation Introduction of new goods – Newer variety of goods are introduced very rapidly in the economy, but the basket of goods is not updated very frequently by the BLS. Therefore the CPI becomes outdated very quickly Changes in quality of goods – goods are often refined and improved and sold for the same price before – implying that we are getting more features for the same price. This change in quality is not reflected in the CPI, which implies it overstates the cost of living Eg.: BLS has “IPhone” in its basket from 2013. But the IPhone of today is not the same as the IPhone from 2013, but it´s being sold at approximately the same price GDP deflator and CPI GDP deflator = reflects prices of all goods produced domestically. Excludes imports, includes exports CPI = reflects prices of all goods consumed domestically. Includes imports, excludes exports CPI is the superior measure w.r.t. prices faced by consumers because imports are a big part of the economy in the modern age Amount in the today dollar = Amount in year T´s dollars * (prices level today/ price level in year T) Regional price parities = measures cost of living changes across the regions of the country Geographical price indices to measure variations of prices across the states How are regional differences explained: 1.) Housing – largest difference between the states 2.) Services – labor costs 3.) Price of goods, including local taxes and transport costs Indexation – automatic correction by law or by contract of dollar amounts payable for the affects of inflation. Ex. Cost of living allowances across states and time Nominal vs real interest rate Nominal interest rate – rate printed on the contract for any debt Real interest rate = Nominal interest rate – rate of inflation