Chapter 11, Measuring the cost of living

The price level: the general purchasing power of a unit of currency, usually measured by a price index.

Real prices are indicated by dividing the nominal price by the price level.

The inflation rate is the annual percentage change in the price level.

The consumer price index, CPI, measures the price level of typical goods and services bought by households.

Which agency computes the CPI?
The Bureau of Labor Statistics.

300 employees gather information on 90,000 goods each month.

The BLS has a master list with 207 categories.

The basket is updated every 10 years, with a few goods updated every 5 years.

The CPI is very important because many cost-of-living increases are based on it.

Including government programs such as social security.


1. Decide on the consumer goods in the "basket".

Set a weight for each good in proportion to purchases.

2. Find the prices for the goods.

3. Compute the cost of the basket.

4. Choose a base year. Compute the index based on that year.

5. Compute the inflation rate: (cpi year 2 - cpi year 1)/(cpi year 1)

The largest category in the cpi housing, 41 percent of the typical household budget.

The producer price index measures the goods typically bought by firms.

Problems with the CPI

Substitution bias.

When goods are cheaper, people buy more.

But the CPI method uses the same quantity of goods for both years.

So the CPI overstates the increase in the cost of living.

Also, the CPI basket remains fixed for 10 years.

During that time, new goods are introduced, replacing old goods.

But the new goods are not included.

Third, the quality of some goods changes.

The Bureau tries to adjust for quality differences, but can't catch all the changes.

So it's important to realize that the official CPI numbers are estimates subject to error.

The GDP deflator versus the CPI.

1. The GDP deflater is based on all of GDP, not just consumer goods.

But the CPI includes imported goods, not counted in GDP.

2. The CPI goods are fixed for 10 years, but the GDP deflator is based on goods currently produced, and changes every year.

To convert prices of one year to that of another year, multiply the price in the current dollars of the year by the price level of the other year, divided by the price level of the first year.

When prices are adjusted for inflation each year, it is called indexing.

Many wages are indexed.

The federal income tax brackets are index, but not capital gains, interest, and depreciation.

The nominal interest rate is the named, quoted rate, as paid in dollars.

The real interest rate is the nominal rate minus the inflation rate.

In economic analysis, we use the real interest rate. We keep it real.