CONSUMER PRICE INDEX (CPI) Measuring the Price LevelThe CPI for any period measures thecost in that period of a standard set, orbasket, of goods and services relative tothe cost of the same basket of goodsand services in a fixed year, called thebase year.
Example:Suppose that a family’s budgetconsists of spending on just threeitems: rent on a two-bedroomapartment, hamburgers, and movietickets.By how much does this family’scost of living increase between 2000and 2008?
This table shows the costs of this family’s spending in both 2000 and 2008 Cost Cost Item (in 2008) (in 2000) Rent, two-bedroom $630 $500 apartment Hamburgers 150 120 (60) ($2.50 each) ($2.00 each) Movie Tickets 70 60 (10) ($7.00 each) ($6.00 each) Total Expenditure $850 $680
InterpretationTherefore, the cost of living in 2008 is 25% higherthan in 2000 (The CPI of the base year is alwaysequal to 1 since in that year the numerator and thedenominator of the CPI formula are the same. TheCPI for a given period (such as a month or a year)measures the cost of living in that period relative towhat is was in the base year.The BSI multiplies the CPI by 100 to get rid of thedecimal point, so the CPI in 2008 is 125 and thebase year CPI is 100.
Exercise 1Suppose that in addition to the three goodsand services the typical family consumed in2000 they also bought four sweaters for $30each. In the year 2008 the sweaters cost$50 each. With this additional item, whatwas the change in the family’s cost of livingbetween 2000 and 2008?
Price IndexThe CPI is not itself the price of a specific good orservice. It has no units of measurement since thedollars in both the numerator and the denominatorcancel out.The CPI is an index. The value of an index in aparticular year has meaning only in comparisonwith the value of that index in another year.The price index measures the average price of aclass of goods or services relative to the price of thesame goods or services in a base year.
Price IndexThe CPI is an especially well-known index, and isused by economists to assess economic trends.There is also the producer price index (PPI) whichis of interest because manufacturers tend to passon increases in the prices of inputs to theircustomers, so economists use indexes of inputprices to try to forecast changes in the prices ofmanufactured goods.Other indexes are used to study the rate of pricechange in energy, food, health care, and othermajor sectors.
Calculating Inflation RatesCPI values for the years 1929-1933 and2003-2007 are shown in the table below.Find the rates of inflation between the years(1929-1933 and 2003-2007).How did the inflation rates in the 1930s differfrom those in the early 2000s? Year CPI Year CPI 1929 171 2003 184 1930 167 2004 188.9 1931 152 2005 195.3 1932 137 2006 201.6 1933 130 2007 207.3
Negative Inflation RatesThe results for the calculations for theinflation rate from 1929 to 1933 showexamples of negative inflation rates.This situation where the prices of most goodsand services are falling over time so thatinflation is negative is called deflation.
Adjusting for InflationThe CPI is an extremely useful tool, as itallows us to measure changes in the cost ofliving and it can be used to adjust economicdata to eliminate the effects of inflation.When the CPI is used to convert quantitiesmeasured at current dollar values into realterms, it is a process called deflating.When it is used to convert real quantities intocurrent-dollar terms, it is a procedure calledindexing.
Example:Suppose that the typical family in a certainmetropolitan area had a total income of$20,000 in year 2000 and $22,000 in year2008. Was this family economically better offin the year 2008 than in the year 2000?(Assume the prices of the goods and servicesrose by 25% percent over that period)
Indexing to Maintain Buying PowerThe CPI can also be used to convert realquantities to nominal quantities.If Congress wants to maintain the buying powerof the Social Security recipients to remainconstant over time, so that their standard ofliving is unaffected by inflation.The nominal, or dollar benefit depends on howmuch inflation has taken place between 2000and 2008. Suppose the CPI has risen 20% overthis period, and the SS benefit is of $1000.So in order for the SS recipients to “keep up”with inflation, their benefit must be $1000 +.20($1000) = $1200 (20% higher than it was in2000.
Indexing to Maintain Buying PowerThis practice of increasing a nominal quantityaccording to changes in a price index to preventinflation from eroding purchasing power iscalled indexing.
Indexing a Labor ContractA labor contract provides for a first-year wageof $12.00 per hour and specifies that the realwage will rise by 2 percent in the second year ofthe contract and by another 2 percent in thethird year. The CPI is 1.00 in the first year,1.05 in the second year, and 1.10 in the thirdyear.What are the dollar wages that must be paid inthe second and third years of the contract?
Indexing a Labor Contract: SolutionBecause the CPI is 1.00 in the first year, boththe nominal and real wage are $12.00. We willlet W2 and W3 be the nominal wages in thesecond and third year.1. Deflating by the CPI in the second year, the real wage is W2/1.05. Since the contract says that the second year real wage must be 2% higher than the real wage in the first year, so W2/1.05 = $12.00(1.02) W2/1.05 = $12.24 W2 = $12.85 Nominal wage required by the contract for the second year must be $12.852. What must the nominal wage be in the thirdyear?
Recap: Methods to Adjust for Inflation1. Deflating: To correct a nominal quantity, such as a family’s dollar income, for changes in the price level, divide it by a price index, such as the CPI. This process, called deflating the nominal quantity, expresses the nominal quantity in terms of real purchasing power. If nominal quantities from two different years are deflated by a price index with the same base year, the purchasing power of the two deflated quantities can be compared.
Recap: Methods to Adjust for Inflation2. Indexing: To insure that a nominal payment, such as a Social Security benefit, represents a constant level of real purchasing power, increase the nominal quantity each year by a percentage equal to the rate of inflation for that year. This process is called indexing.