Measuring the Cost of Living
Last time we discussed the most important measure of economic well-being – real, per capita GDP. Further, if we want to see how our economic well-being is changing over time, we can calculate how real GDP is changing in percentage terms (for example, real GDP grew 4% last quarter).
Now, we turn our attention to another important measure of the economy.
We want to measure how the cost of living changes over time.
The main intuition here is that, over time, peoples’ incomes and the prices of goods and services increase. 30 years ago an ice cream sundae cost $1 and a typical economics professor earned $35,000. Now, a (bad) ice cream ...view middle of the document...
From 2001 to 2002: Both nominal and real GDP increased by the same amount ($50), which must mean that the only thing causing these increases was an increase in the quantities – we had no inflation!
So, you can see that we can use the relationship between nominal and real GDP to understand changes in the cost of living.
The question now is how, precisely, we do this:
The GDP Deflator = (Nominal GDP/Real GDP)*100.
GDP Deflator is the ratio of nominal GDP to real GDP…
So, For example: if nominal GDP = 200 and real GDP = 100 then the GDP deflator = 200.
Now, let’s move on to our other measure of the cost of living: the consumer price index:
The Consumer Price Index:
Suppose upon graduation you have to decide between two job offers: one in Richmond that will pay you $35,000 a year, and one in Indianapolis that will pay you $40,000 a year. Which offer affords you a better living standard?
To answer this question you need to compare the cost of living in Richmond to Indianapolis and then adjust the income figures accordingly.
My question to you is: How can you do this?
The Consumer Price Index is the way to go: it is a measure of the overall cost of the goods and services bought by a typical consumer.
As such, we tend to be more interested in the CPI than in the GDP deflator…
Calculating the CPI is a straightforward, five step process:
Step 1: Fix the Basket.
We have to figure out what a “typical” consumer buys. Imagine a shopping cart – you fill it up with items that a typical consumer will purchase.
Step 2: Find the prices:
Now that we have our basket, we can track prices on the items in the cart and see how much it all costs.
Step 3: Compute the cost of the basket:
Let’s determine the cost of the basket from year to year
Step 4: Choose a base year, and compute the index:
Pick a year to serve as a benchmark – a comparison basket cost for all other years. We then can use the cost in benchmark year (called a “base year”) relative to the cost of the cart in the year we are interested in to calculate a cost if living index.
Step 5: Compute the inflation rate:
This is easy: just calculate how the index changes from year to year in percentage terms.
To see these steps in action, consider the following example (from the textbook):
Step 1: Fix the basket:
Well, suppose that what we see consumers typically buying are 4 hot dogs and 2 hamburgers – that is what is in their shopping cart…
Step 2: Find the price of each good in each year:
This is just observing prices every year…
Year: Price of hot dogs: Price of hamburgers:
2001 $1 $2
2002: $2 $3
2003: $3 $4
Step 3: Compute the cost of the basket in each year:
Let’s see how much the stuff in the cart costs from year to year…
Year: Cost of basket:
2001. $1*4 + $2*2 = $8
2002. $2*4 + $3*2 = $14
2003. $3*4 + $4*2 = $20
Step 4: Choose a...