Topic 9: Measuring

the Cost of Living

ECON 1010I / UGEC 1511I

Perspectives in Economics

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Introduction

Inflation is generally not welcomed because

money loses value (purchasing power)

Inflation is defined as the percentage change

in the general price level, P

P is measured by a price index such as the

GDP deflator, and the consumer price index

(CPI)

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Hyperinflation in China

(1947 – 1948)

Hyperinflation occurs

when the inflation rate

exceeds 50 percent

per month

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Consumer Price Index (CPI)

The consumer price index (CPI) is a measure

of the overall cost of the goods and services

bought by a typical consumer

It is a cost of living measure

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Computing the Inflation Rate

1. Choose a fixed basket of consumption goods.

It is the combination of goods bought by a

typical consumer

It represents the (fixed) living standard

enjoyed by a typical consumer

2. Find the prices in each period

3. Compute the basket’s cost in each period

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Computing the Inflation Rate

4. Choose a base year. Divide the total cost in

current year by the base-year cost (and

multiply by 100 to make it more “user-

friendly”). That gives the CPI:

100x yearbase in basket of cost

yearcurrent in basket of costCPI

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Computing the Inflation Rate

5. The inflation rate is defined as the

percentage change in the price index.

CPI this year – CPI last year

CPI last year

inflation

rate x 100% =

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EXAMPLE basket: {4 pizzas, 10 lattes}

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3

$2.5

$2

price of

latte

$12 2012

$11 2011

$10 2010

price of

pizza year

Compute CPI in each year:

2010: ($60/$60) x 100 = 100

2011: ($69/$60) x 100 = 115

2012: ($78/$60) x 100 = 130

15%

13%

Inflation rate:

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Exercise: Calculate the CPI

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The basket contains

20 movie tickets

and 10 textbooks

The table shows their

prices for 2010-2012

The base year is 2010

A. How much did the basket cost in 2010?

B. What is the CPI in 2011?

C. What is the inflation rate from 2011-2012?

movie

tickets

text-

books

2010 $10 $50

2011 $10 $60

2012 $12 $60

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Answers

A. How much did

the basket

cost in 2010?

($10 x 20) + ($50 x 10) = $700

movie

tickets

text-

books

2010 $10 $50

2011 $10 $60

2012 $12 $60

The basket contains

20 movie tickets

and 10 textbooks.

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Answers

B. What is the

CPI in 2011?

cost of basket in 2011

= ($10 x 20) + ($60 x 10) = $800

CPI in 2011 = ($800/$700) x 100 = 114.3

movie

tickets

text-

books

2010 $10 $50

2011 $10 $60

2012 $12 $60

The basket contains

20 movie tickets

and 10 textbooks.

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Answers

C. What is the

inflation rate

from 2011-2012?

cost of basket in 2012

= ($12 x 20) + ($60 x 10) = $840

CPI in 2012 = ($840/$700) x 100 = 120

Inflation rate = (120 – 114.3)/114.3 = 5%

movie

tickets

text-

books

2010 $10 $50

2011 $10 $60

2012 $12 $60

The basket contains

20 movie tickets

and 10 textbooks.

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What’s in the CPI’s Basket?

CPI(A) relates to about 50% of households in

Hong Kong, which are in the relatively low

expenditure range

For CPI(A)

Clothing and Footwear = 3%

Food = 34%

Housing = 32%

Transport = 7%

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Major Uses of CPI

As an economic indicator, reflecting

Overall price level, and

Cost of living

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Inflation Rate of HK: CPI(A)

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Deflation

Deflation occurs when the price level falls.

a negative inflation rate

Hong Kong experienced a long deflation

period from autumn 1998 to summer 2004

CPI(A) was 103.7 in 1998 and 90.7 in 2004

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Problems With the CPI:

Substitution Bias

Over time, some prices rise faster than others

Consumers substitute toward goods that

become relatively cheaper

The CPI misses this substitution because it

uses a fixed basket of goods

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Problems With the CPI:

Introduction of New Goods

When new goods become available, variety

increases, allowing consumers to find

products that more closely meet their needs

This has the effect of making each dollar

more valuable

The CPI misses this effect because it uses a

fixed basket of goods

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Problems With the CPI:

Unmeasured Quality Change

Quality improvements that lead to price

increases are usually considered purely

inflationary in the data

Eg: Bus fare (no AC) last year was $5. This

year, bus with AC costs you $10. Data says

price goes up by 100%

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Problems With the CPI

Each of these problems causes the CPI to

overstate increases in the cost of living

GDP Deflator is an alternative

Refer to Topic 8

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The GDP Deflator Vs the CPI

GDP deflator and CPI generally move together.

Sometimes they do diverge because:

1. GDP deflator covers all goods produced

domestically, while the CPI covers all goods

bought by consumers (including imported goods)

2. CPI covers a fixed basket of goods over time,

while the goods included in the GDP deflator

change automatically over time as output

changes

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Correcting Economic Variables

for the Effects of Inflation

Inflation makes it harder to compare dollar

amounts from different times

We can use the CPI to adjust figures so that

they can be compared

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Correcting Economic Variables

for the Effects of Inflation

Starting salary of a university graduate in

2005 = $10500

Starting salary of a university graduate in

2013 = $12000

Did the salary have more purchasing power

in 2005 or 2013?

To compare, use CPI to convert 2005

figure into “2013 dollars”…

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Example:

2005 salary in 2013 dollars

= $10500 x 106.4/91.7 = $12183

After correcting for inflation, 2005 salary is

actually slightly higher than in 2013

106.4 $12000 2013

91.7 $10500 2005

CPI Salary Year

$12000

$12183

Salary in 2013

dollars

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Real Vs Nominal Interest Rates

The nominal interest rate:

the interest rate not corrected for inflation

The real interest rate:

corrected for inflation

the rate of growth in the purchasing power

of a deposit or debt

Real interest rate

= Nominal interest rate – Inflation rate

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Real Vs Nominal Interest Rate

Suppose you have $100 in your savings

account earning 3% interest. Inflation rate is

5%.

In nominal terms, you get $103 next year

In real terms, you get:

$103 / (1 + 5%) = $98

real interest rate = 3% – 5% = –2% < 0

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Real Interest Rate in HK

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Real Interest Rate

Real interest rate (rather than the nominal

interest rate) is a critical determinant of

investment

It is usually low in good times, high in bad

times