Measuring the cost of living (1. The Consumer Price Index (CPI) (How to…
Measuring the cost of living
1. The Consumer Price Index (CPI)
a measure of overall cost of goods and services bought by a typical consumer. It is calculated every month
How to calculate it?
Fix the basket
Surveying consumers to determine the basket of goods and services
Find the prices
Find the prices of each of the goods and services in the basket
at each point in time.
Calculate the basket's cost
Multiply the amount of good with its price at different time
Choose a base year and compute the index
CPI Index= (Price of basket current year/price of basket baseyear)X100
Compute the inflation rate
the change of percentage in the price index from the preceding year
nflation rate= [(CPI year 2- CPI year 1)/CPI year 1] x 100
A measure to predict CPI
Producer Price Index (PPI):
a measure of cost of goods and services bought by producer
Reason why it can be used to predict CPI:
Producer pass on its cost in the form of higher consumer prices
Problems of CPI
The CPI assumes that the amount of goods & services is constant. It ignores the possibility of consumers substitution
Introduction of new goods.
New variety of goods add more value to the money, and it reduces the cost of living
Unmeasured quality change.
The change of goods/services quality changes the value of money.
Differences between GDP deflator and CPI
reflects the prices of all goods and service
reflects the prices of goods and services
bought by consumer
compares the price of
goods and services to the price of same goods and services in the base year.
compares the price of
to the price of basket in the base year
CPI can be used to correct for the effects of inflation when comparing dollar figures from different times
2. Correcting Economic Variables for the Effects of Inflation
Comparing the value of money in the past year and current year
To know whether the value of money is higher/lower compared to the past, we need to know the price level of T year and the price level of today's year
We can use this formula.
Amount in today's money= amount in T year money x (Current CPI/T year CPI)
the automatic correction of money amount by law or contract for the effects of inflation
Real vs nominal interest rate
Real interest rate:
The interest rate corrected for the effects of inflation
It tells how fast the purchasing power rises overtime
Nominal interest rate:
The interest rate that measures change in the amount of money
It tells how fast the amount of money rises overtime
Real interest rate = nominal interest rate - rate of inflation