© 2007 Thomson South-Western

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Measuring the Cost of Living Inflation refers to a situation in which the

economy’s price level is rising. The inflation rate is the rate of change in

the price level from the previous period (month or year).

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THE CONSUMER PRICE INDEX The consumer price index (CPI) is a

measure of the overall cost of the goods and services bought by a typical consumer. CPI is one way of measuring the price level.

It is used to monitor changes in the cost of living over time.

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THE CONSUMER PRICE INDEX

When the CPI increases, the average family has to spend more money to maintain the same standard of living.

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How the CPI Is Calculated1. Fix the basket. Determine the quantity of

each good that the average consumer buys. Identify a basket of goods and services the

typical consumer buys. Conduct monthly consumer surveys to

determine the quantities of those goods and services.

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How the CPI Is Calculated2. Find the prices. Find the prices of each of

the goods and services in the basket for each period (month or year).

3. Calculate the cost of the basket. Use the data on prices to calculate the cost of the basket of goods and services at each period.

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How the CPI Is Calculated4. Choose a base year and compute the

index. Choose one year as the base year, so that we

can compare across years more clearly. Compute the index by dividing the cost of the

basket in one year by the cost of the basket in the base year and multiplying by 100.

100basket ofCost Year Base

basket theofCost Current CPI

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How the CPI Is Calculated5. Calculate the inflation rate. The inflation

rate is the rate of change in the consumer price index between years (or months).

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How the CPI Is Calculated

The inflation rate is calculated as follows:

CPI in Year 2 CPI in Year 1Inflation Rate in Year 2= 100

CPI in Year 1

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Table 1: Calculating the Consumer Price Index and the Inflation Rate: An Example

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Table 1: Calculating the Consumer Price Index and the Inflation Rate: An Example

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How the CPI Is Calculated Calculating the Consumer Price Index and

the Inflation Rate: Another Example Base Year is 2002. Basket of goods in 2002 costs 1,200 YTL. The same basket in 2004 costs 1,236 YTL. CPI = (1,236/1,200) 100 = 103. Prices increased by 3 percent between 2002

and 2004. (Remember that base year CPI is always 100)

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What Is in the CPI’s Basket? (US data)

17%Transportation

15%Food and beverages

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

42%Housing

6%Education and communication

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CPI in Turkey CPIinflation

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

months

CPIinflation

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Problems in Measuring the Cost of Living The CPI is a good but not a perfect

measure of the cost of living because it fixes the basket. Problems include:

Substitution bias (overestimates inflation) Introduction of new goods Unmeasured quality changes

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Problems in Measuring the Cost of Living Substitution Bias The basket does not change to reflect

consumer’s reaction to changes in relative prices.

Consumers substitute away from goods that have become relatively more expensive toward goods that have become cheaper. Think about benzene (gasoline) and LPG.

But CPI ignores this consumer reaction. Therefore the index overestimates the actual inflation rate by not considering the substitution effect.

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Problems in Measuring the Cost of Living Introduction of New Goods

The basket does not reflect the change in purchasing power brought on by the introduction of new products. Think about a new Nokia cell phone coming to Turkey in March. Increases standard of living. But the CPI basket is fixed, ignores new products.

New products result in greater variety, which in turn makes each YTL more valuable.

Consumers need fewer liras to maintain the same standard of living.

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Problems in Measuring the Cost of Living Unmeasured Quality Changes

If the quality of the same good rises from one year to the next, and its price does not change, the value of one YTL rises, Ex1: Airbags became standard in cars, but assume that price of a car did not increase much. Ex2: Cell phones developed a lot in last 10 years but prices did not increase as much.

TURKSTAT tries to adjust the price for constant quality, but it is hard to measure quality.

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Problems in Measuring the Cost of Living The substitution bias, introduction of new

goods, and unmeasured quality changes cause the CPI to overestimate the true cost of living.

The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. (indexing)

The CPI overestimates inflation by about 1 percentage point per year.

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Other Indices: Indices for different regions within the

country, such as Istanbul, Ankara, etc. For various categories of goods such as

food, energy, housing etc. The producer price index (PPI), which

measures the cost of a basket of goods and services bought by firms rather than consumers. PPI is used for predicting future CPI inflation.

Wholesale Price Index (WPI)

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WPI in TR WholesalePriceIndex-%change

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

130.0

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

years

% CHANGE

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The GDP Deflator versus the CPI

The GDP deflator is calculated as follows:

G D P d efla to r =N o m in a l G D P

R eal G D P 1 0 0

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The GDP Deflator versus the CPI Economists and policymakers monitor both

the GDP deflator and CPI to measure how quickly prices are rising.

There are two important differences between GDP deflator and CPI.

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The GDP Deflator versus the CPI GDP deflator measures the prices of all

goods and services produced in this country, whereas...

…the CPI reflects the prices of all goods and services purchased by the average consumer. So CPI includes prices of imported goods, such as oil, natural gas, imported cars, etc. (deflator does not)

Does CPI include prices of military equipment produced by Aselsan in Turkey? Does GDP Deflator include it?

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Figure 2: Two Measures of Inflation in US

1965

Percentper Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995 2005

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Figure 3: Two Measures of Inflation in TR

GDP deflator vs CPI

0

10

20

30

40

50

60

70

80

90

100

110

1997 1998 1999 2000 2001 2002 2003 2004 2005

GDPDeflator

CPI

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Correcting Economic Variables For The Effects Of Inflation Real value of 1 lira is different across time

due to inflation. Price indices are used to correct for the

effects of inflation when comparing lira figures from different times.

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Lira Figures from Different Times Do the following to convert lira values

from time T into today’s liras:

Amount intoday’s liras

Amount in time T’s liras

Price level today

Price level in time T X

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TL Figures from Different Times Let us convert Adrian Ilie’s transfer payment to

Beşiktaş, 234 000 liras in January 2004 into liras of January 2008:

YTL

YTL

inCPI

inCPIPaymentPayment

060,32881.104

94.146000,234

2004/01

2008/012004/012008/01

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Indexation When some TL amount is automatically

corrected for inflation by law or contract, the amount is said to be indexed for inflation.

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Table 2 The Most Popular Movies of All Times, Adjusted for Inflation

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Real and Nominal Interest Rates Interest rate is the cost of borrowing

money (credit) for a specified period of time. It is the cost of renting money for a month or year.

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Real and Nominal Interest Rates The nominal interest rate is the interest

rate usually quoted in the banking system and not corrected for inflation. It is the interest rate that a bank pays. Ex:

Suppose the bank pays 15% annual interest rate on 100 YTL you deposit now. Then you will receive 100 YTL as principal + 15 YTL as interest payment one year from now. Are you 15% richer in terms of goods & services you can buy? No. Because there is inflation.

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Real and Nominal Interest Rates The real interest rate is the interest rate

that is corrected for the effects of inflation. It measures real return on your deposit.

You deposited 100 YTL for one year. Annual nominal interest rate is 15%. Suppose during the next year, people

expect that inflation will be 8%.

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Real and Nominal Interest Rates Then Fisher Equation says that:

Real Interest Rate = 15% – 8% = 7%

You will receive 115 YTL next year, but this will buy only 107 liras worth of goods & services. You are 7% richer in real terms. You will have 7% more purchasing power.

Inflation Expected– RateInterest Nominal RateInterest Real

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Unexpected Inflation If actual inflation turns out to be greater

than expected inflation, then lenders (depositors) lose and borrowers gain.

If actual inflation becomes 15% instead of 8%, then your real return on your deposit becomes 0%, not 7%. You (lender) lose and bank (borrower) gains.

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Real and Nominal Interest Rates in TR

-40

-30

-20

-10

0

10

20

30

40

50

60

70

80

90

100

110

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

NomIntRate

RealIntRate

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Figure 3 Real and Nominal Interest Rates (US)

1965

Interest Rates(percentper year)

15%

Real interest rate

10

5

0

51970 1975 1980 1985 1990 1995 2000 2005

Nominal interest rate

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The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year.

CPI is used to measure the price level in the economy.

The percentage change in the CPI measures the inflation rate.

Summary

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The GDP deflator differs from the CPI because deflator considers goods and services produced but CPI considers goods and services consumed.

In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Summary

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Lira figures from different points in time do not represent a correct comparison of purchasing power.

Fisher equation says that the real interest rate equals the nominal interest rate minus the rate of inflation.

Summary