topic 9. measuring the cost of living
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Topic 9: Measuring
the Cost of Living
ECON 1010I / UGEC 1511I
Perspectives in Economics
1
2
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)
3
Hyperinflation in China
(1947 – 1948)
Hyperinflation occurs
when the inflation rate
exceeds 50 percent
per month
4
5
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:
10
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.
12
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.
13
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