Chapter 7 CPI & Cost of Living

Two Consequences of the CPI Bias

Bias leads to • Distortion of private contracts • Increases in government outlays and decreases in taxes

The CPI Market Basket The first stage in constructing the CPI is to determine the CPI market basket.

This "basket" contains the goods and services represented in the index and the relative importance, or weight, attached to each of them. The idea is to make the weight of the items in the CPI basket the same as in the budget of an average urban household.

Nominal and Real Values in Macroeconomics Macroeconomics makes a big issue of the distinction between nominal and real values.

Three nominal and real variables occupy a central position in macroeconomics. They are • Nominal GDP and real GDP • The nominal wage rate and the real wage rate • The nominal interest rate and the real interest rate

PCE price index An average of the current prices of the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base-year prices.

A weakness of the PCE price index is that it is based on data that become known after the lapse of several months. So the CPI provides more current information about the inflation rate than what the PCE price index provides

Core inflation rate The annual percentage change in the PCE price index excluding the prices of food and energy.

By excluding these highly variable items, the underlying price level and inflation trends can be seen more clearly

The Monthly Price Survey

Each month, BLS employees check the prices of the 80,000 goods and services in the CPI market basket in 30 metropolitan areas. Because the CPI aims to measure price changes, it is important that the prices recorded each month refer to exactly the same items.

Inflation rate The percentage change in the price level from one year to the next.

If the inflation rate is negative, the price level is falling and we have deflation.

Consumer Price Index A measure of the average of the prices paid by urban consumers for a fixed market basket of consumption goods and services.

The Bureau of Labor Statistics (BLS) calculates the CPI every month, and we can use these numbers to compare what the fixed market basket costs this month with what it cost in some previous month or other period.

Reference base period A period for which the CPI is defined to equal 100. Currently, the reference base period is 1982-1984.

The CPI is defined to equal 100 for a period called the reference base period. That is, the CPI equals 100 on the average over the 36 months from January 1982 through December 1984.

The CPI is sometimes called a cost of living index—a measure of the change in the amount of money that people need to spend to achieve a given standard of living

The purpose of the CPI is to measure the cost of living or what amounts to the same thing, the value of money

Real wage rate The average hourly wage rate measured in the dollars of a given reference base year.

To calculate the real wage rate relevant to a consumer, we divide the nominal wage rate by the CPI and multiply by 100. That is, Real wage rate in 2011 equals Normal wage rate in 2011 -------------------------------------------------------------- over CPI in 2011 × 100.

GDP price index An average of the current prices of all the goods and services included in GDP expressed as a percentage of base-year prices.

Two key differences between the GDP price index and the CPI result in different estimates of the price level and inflation rate. CPI uses prices of consumption goods and services only the CPI weights each item using information from a past Consumer Expenditure Survey.

The CPI calculation has three steps: CPI equals Cost of CPI basket at current period prices ------------------------------------------------------------- over Cost of CPI basket at base period prices × 100.

• Find the cost of the CPI market basket at base period prices. • Find the cost of the CPI market basket at current period prices. • Calculate the CPI for the base period and the current period.

Sources of Bias in the CPI

• New goods bias • Quality change bias • Commodity substitution bias • Outlet substitution bias

Constructing the CPI is a huge operation that costs millions of dollars and involves three stages:

• Selecting the CPI market basket • Conducting the monthly price survey • Calculating the CPI