Measuring the Cost of Living 24 Measuring the Cost of Living Economics P R I N C I P L E S O F N. Gregory Mankiw This chapter can probably be covered in 1-1.5 class sessions. It would be helpful if your students had calculators so they can compute a CPI example and an example of using the CPI to compare dollar figures from different years. Premium PowerPoint Slides by Ron Cronovich

In this chapter, look for the answers to these questions: What is the Consumer Price Index (CPI)? 소비자물가지수란? How is it calculated? What’s it used for? What are the problems with the CPI? How serious are they? 소비자물가지수의 문제는 무엇? How does the CPI differ from the GDP deflator? GDP 디플레이터와는 어떻게 다른가? How can we use the CPI to compare dollar amounts from different years? Why would we want to do this, anyway? 서로 다른 시점의 금액을 비교하는데 소비자물가지수를 어떻게 사용하는가? 왜 하는가? How can we correct interest rates for inflation? 인플레이션을 감안한 이자율의 보정 1

The Consumer Price Index (CPI) measures the typical consumer’s cost of living 전형적인 소비자의 생계비를 측정 the basis of cost of living adjustments (COLAs) in many contracts and in Social Security 많은 계약들과 사회보장에서 생계비조정의 토대가 됨 MEASURING THE COST OF LIVING 2

How the CPI Is Calculated Fix the “basket.”재화묶음(장바구니) 결정 The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 통계청에서 전형적인 소비자의 “장바구니”에 무엇이 담기는지를 결정하기 위해 소비자들을 조사함 Find the prices. 가격조사 The BLS collects data on the prices of all the goods in the basket. 장바구니 속의 모든 재화의 가격을 수집 Compute the basket’s cost. 비용계산 Use the prices to compute the total cost of the basket. MEASURING THE COST OF LIVING 3

How the CPI Is Calculated Choose a base year and compute the index. The CPI in any year equals 100 x cost of basket in current year cost of basket in base year Compute the inflation rate. The percentage change in the CPI from the preceding period. CPI this year – CPI last year CPI last year Inflation rate x 100% = MEASURING THE COST OF LIVING 4

basket: {4 pizzas, 10 lattes} EXAMPLE basket: {4 pizzas, 10 lattes} $3.00 $2.50 $2.00 price of latte $12 2009 $11 2008 $10 2007 price of pizza year cost of basket $10 x 4 + $2 x 10 = $60 $11 x 4 + $2.5 x 10 = $69 $12 x 4 + $3 x 10 = $78 Compute CPI in each year 2007: 100 x ($60/$60) = 100 2008: 100 x ($69/$60) = 115 2009: 100 x ($78/$60) = 130 using 2007 base year: Inflation rate: Suggestion: Show students the data in the first three columns of the table. Before showing them the cost of basket calculations, tell them to take 3 minutes to compute the cost of the basket in each of the three years, and use those results to compute the value of the CPI in each of the three years. Then, show the rest of the slide. Or, you can just cruise through this example, but tell them to pay close attention because in a few moments they will have to compute a similar example. 15% 115 – 100 100 x 100% = 13% 130 – 115 115 x 100% = MEASURING THE COST OF LIVING 5

A C T I V E L E A R N I N G 1 Calculate the CPI A C T I V E L E A R N I N G 1 Calculate the CPI price of beef price of chicken 2004 $4 2005 $5 2006 $9 $6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year. A. Compute the CPI in 2005. B. What was the CPI inflation rate from 2005-2006? Part A is not difficult but requires an intermediate step: students must compute the cost of the basket in 2005 to find the CPI in 2005. Part B has two intermediate steps: computing the cost of the basket in 2006, then computing the CPI in 2006. 6

A C T I V E L E A R N I N G 1 Answers A C T I V E L E A R N I N G 1 Answers price of beef price of chicken 2004 $4 2005 $5 2006 $9 $6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year. A. Compute the CPI in 2005: Cost of CPI basket in 2005 = ($5 x 10) + ($5 x 20) = $150 CPI in 2005 = 100 x ($150/$120) = 125 7

A C T I V E L E A R N I N G 1 Answers A C T I V E L E A R N I N G 1 Answers price of beef price of chicken 2004 $4 2005 $5 2006 $9 $6 CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2004, the base year. B. What was the inflation rate from 2005-2006? Cost of CPI basket in 2006 = ($9 x 10) + ($6 x 20) = $210 CPI in 2006 = 100 x ($210/$120) = 175 CPI inflation rate = (175 – 125)/125 = 40% 8

What’s in the CPI’s Basket? This slide replicates Figure 1 from the textbook. Source: Bureau of Labor Statistics, http://www.bls.gov/cpi/ This graph shows just a few highly aggregated categories. A more detailed breakdown is available at the BLS website: look for “Relative Importance of Components in the Consumer Price Index” there. MEASURING THE COST OF LIVING 9

A C T I V E L E A R N I N G 2 Substitution bias (대체효과에 따른 왜곡) A C T I V E L E A R N I N G 2 Substitution bias (대체효과에 따른 왜곡) CPI basket: {10# beef, 20# chicken} 2004-5: Households bought CPI basket. 2006: Households bought {5 lbs beef, 25 lbs chicken}. beef chicken cost of CPI basket 2004 $4 $120 2005 $5 $150 2006 $9 $6 $210 Students understand substitution bias better if they work a concrete example like the one on this slide. Before displaying the questions (A + B), you might want to ask your class why households bought different quantities of beef and chicken in 2006 than they did in 2005. Or if that seems too easy, just mention before displaying questions A and B that households are responding to the change in relative prices: beef has become a lot more expensive relative to chicken, so households buy less beef and more chicken. A. Compute cost of the 2006 household basket. B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate. 10

A C T I V E L E A R N I N G 2 Answers CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} beef chicken cost of CPI basket 2004 $4 $120 2005 $5 $150 2006 $9 $6 $210 This is just a straight-forward calculation. A. Compute cost of the 2006 household basket. ($9 x 5) + ($6 x 25) = $195 11

A C T I V E L E A R N I N G 2 Answers CPI basket: {10# beef, 20# chicken} Household basket in 2006: {5# beef, 25# chicken} beef chicken cost of CPI basket 2004 $4 $120 2005 $5 $150 2006 $9 $6 $210 Ask students which inflation rate (30% or 40%) they think more accurately measures the true increase in the cost of living for this example. Most students will correctly say “30%.” Ask them to explain their reasoning. You are guiding them to figure out substitution bias and why it’s a problem. B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate. Rate of increase: ($195 – $150)/$150 = 30% CPI inflation rate from previous problem = 40% 12

Problems with the CPI: Substitution Bias Over time, some prices rise faster than others. 시간이 흐름에 따라 어떤 재화의 가격이 다른 재화의 가격보다 빨리 상승 Consumers substitute toward goods that become relatively cheaper. 소비자들은 상대적으로 값싸진 재화로 소비를 대체 The CPI misses this substitution because it uses a fixed basket of goods. 소비자물가지수는 고정된 바스킷을 사용하므로 이러한 대체를 파악할 수 없음 Thus, the CPI overstates increases in the cost of living. 따라서 소비자물가지수는 생계비의 인상을 과대평가 If you spent a few minutes of class time on the preceding exercise, you can go through this slide fairly quickly. MEASURING THE COST OF LIVING 13

Problems with the CPI: Introduction of New Goods The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. 새로운 재화의 등장은 다양성을 증대시켜 소비자가 자신의 필요에 더 맞는 제품을 발견할 수 있게 해준다. In effect, dollars become more valuable. 결과적으로 화폐가치가 증대된다. The CPI misses this effect because it uses a fixed basket of goods. 소비자물가지수는 고정 바스킷을 사용하므로 이러한 효과를 반영하지 못한다. Thus, the CPI overstates increases in the cost of living. 따라서 소비자물가지수는 생계비의 인상을 과대평가한다. MEASURING THE COST OF LIVING 14

Problems with the CPI: Unmeasured Quality Change Improvements in the quality of goods in the basket increase the value of each dollar. 바스킷 안에 있는 재화의 질 개선은 화폐가치를 상승시킴 The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. 통계청은 질적 변화를 계산하려고 노력하지만 질이란 측정하기 힘든 것이어서 일부 밖에 반영되지 못한다. Thus, the CPI overstates increases in the cost of living. 따라서 소비자물가지수는 생계비 인상을 과대평가한다. MEASURING THE COST OF LIVING 15

Problems with the CPI Each of these problems causes the CPI to overstate cost of living increases. 이러한 일련의 문제들로 인해 소비자물가지수는 생계비 인상을 과대평가한다. The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. 통계청은 기술적인 조정을 해왔지만 여전히 소비자물가지수는 매년 약 0.5% 증도 인플레이션을 과대평가하는 것 같다. This is important because Social Security payments and many contracts have COLAs tied to the CPI. 이는 사회보장이나 많은 계약들이 소비자물가지수와 연동된 생계비조정을 하고있기 때문에 매우 중요하다. In the 1990s, it was estimated that the CPI’s bias cost taxpayers $1 trillion every 12 years in unnecessary COLAs in Social Security and government pension payments!!! MEASURING THE COST OF LIVING 16

Two Measures of Inflation, 1950-2007 This figure shows the inflation rate – the percentage change in the level of prices – as measured by the GDP deflator and the Consumer Price Index using quarterly data from the U.S. economy. Notice that the two measures of inflation generally move together. There are a few years when they diverge a bit. The reasons for this are on the next slide. Sources: GDP deflator – Bureau of Economic Analysis, U.S. Dept of Commerce CPI – Bureau of Labor Statistics, U.S. Dept of Labor I obtained both from the Federal Reserve Bank of St. Louis “Fred” database: http://research.stlouisfed.org/fred2/ MEASURING THE COST OF LIVING 17

Contrasting the CPI and GDP Deflator Imported consumer goods: included in CPI excluded from GDP deflator Capital goods: excluded from CPI included in GDP deflator (if produced domestically) The basket: CPI uses fixed basket GDP deflator uses basket of currently produced goods & services This matters if different prices are changing by different amounts. 여러 재화가격의 변동폭이 서로 다를 경우 문제가 됨 MEASURING THE COST OF LIVING 18

A C T I V E L E A R N I N G 3 CPI vs. GDP deflator In each scenario, determine the effects on the CPI and the GDP deflator. A. Starbucks raises the price of Frappuccinos. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. C. Armani raises the price of the Italian jeans it sells in the U.S. To make this exercise more challenging, move the preceding slide so that it appears immediately after the answers to this exercise. If you are outside the U.S., please make the following changes: In (b), change the example to “A local manufacturer raises the price on industrial tractors it produces.” In (c), change “U.S.” to your country’s name, unless your country is Italy. In that case, change the example to something involving an imported consumer good. 19

A C T I V E L E A R N I N G 3 Answers A. Starbucks raises the price of Frappuccinos. The CPI and GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not. Explanations: A. Frappuccinos are produced in the U.S., so their prices are part of the GDP deflator. They are purchased by consumers, so their prices are part of the CPI. Hence, an increase in the price of Frappuccinos causes both the CPI and GDP deflator to increase. B. Since the tractors are produced here in the U.S., the price increase causes the GDP deflator to rise. However, industrial tractors are a capital good, not a consumer good, so the CPI is unaffected. C. Italian jeans appear in the U.S. consumer’s shopping basket, and hence the increase in their price causes the CPI to rise. However, the GDP deflator is unchanged because it only includes prices of domestically produced goods and excludes the prices of imports. 20

Example: the minimum wage 최저임금의 예 Correcting Variables for Inflation(인플레효과의 조정): Comparing Dollar Figures from Different Times 서로 다른 시점의 화폐가치 비교 Inflation makes it harder to compare dollar amounts from different times. 인플레는 서로 다른 시점의 금액을 비교하기 힘들게 한다. Example: the minimum wage 최저임금의 예 $1.15 in Dec 1964 $5.85 in Dec 2007 Did min wage have more purchasing power in Dec 1964 or Dec 2007? 1964년과 2007년 중 어느 해의 최저임금이 더 큰 구매력을 갖는가? To compare, use CPI to convert 1964 figure into “today’s dollars”… 비교를 위해 소비자물가지수를 이용해서 1964년의 화폐가치를 오늘날의 가치로 환산해보자. 21

Correcting Variables for Inflation: Comparing Dollar Figures from Different Times Amount in today’s dollars Amount in year T dollars Price level today Price level in year T = x In our example, year T = 12/1964, “today” = 12/2007 Min wage = $1.15 in year T CPI = 31.3 in year T, CPI = 211.7 today Note: the ratio of price levels = 211.7/31.3 = 6.76. This means that the cost of living has increased by a factor of 6.76. We multiply this factor by the 1964 figure to convert the latter into “today’s dollars.” Interpreting the result: The $1.15 minimum wage in December 1964 could have purchased $7.78 worth of goods and services if prices in 1964 equaled their December 2007 level. Source of data: Bureau of Labor Statistics, www.bls.gov The minimum wage in 1964 was $7.78 in today’s (2007) dollars. 211.7 31.3 $7.78 = $1.15 x MEASURING THE COST OF LIVING 22

Correcting Variables for Inflation: Comparing Dollar Figures from Different Times Researchers, business analysts and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures. 연구자들, 산업분석가들 그리고 정책결정자들은 현재 금액 수치(명목수치)의 시계열을 불변 금액 수치(실질수치)로 변환하기 위해 이 테크닉을 종종 사용한다. They can then see how a variable has changed over time after correcting for inflation. 그렇게 했을 경우 그들은 인플레효과를 조정한 이후 한 변수가 어떻게 시간의 흐름에 따라 변화해 왔는지를 볼 수 있다. Example: the minimum wage, from Jan 1950 to Dec 2007… DISCLAIMER: The material on this slide is not supported with test bank or study guide questions. MEASURING THE COST OF LIVING 23

The U.S. Minimum Wage in Current Dollars and Today’s Dollars, 1950-2007 $9 2007 dollars $8 $7 $ per hour $6 $5 $4 DISCLAIMER: The material on this slide is not supported with test bank or study guide questions. Source: http://www.bls.gov $3 current dollars $2 $1 $0 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

A C T I V E L E A R N I N G 4 Converting to “today’s dollars” Annual tuition and fees, average of all public four-year colleges & universities in the U.S. 1986-87: $1,414 (1986 CPI = 109.6) 2006-07: $5,834 (2006 CPI = 203.8) After adjusting for inflation, did students pay more for college in 1986 or in 2006? Convert the 1986 figure to 2006 dollars and compare. Sources: Data on tuition and fees from Trends in College Pricing 2006, the College Board, www.collegeboard.com CPI from BLS.gov. 25

A C T I V E L E A R N I N G 4 Answers Annual tuition and fees, average of all public four-year colleges & universities in the U.S. 1986-87: $1,414 (1986 CPI = 109.6) 2006-07: $5,834 (2006 CPI = 203.8) Solution Convert 1986 figure into “today’s dollars” $1,414 x (203.8/109.6) = $2,629 Even after correcting for inflation, tuition and fees were much lower in 1986 than in 2006! If prices were as high in 1986 as they were in 2006, then tuition & fees in 1986 would have been $2,629, less than half as much as actual tuition & fees in 2006! Tuition and fees have risen much faster than the overall cost of living. 26

Correcting Variables for Inflation: Indexation(물가연동제) A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract.법률이나 계약에 따라 인플레이션효과를 자동적으로 조절하는 것을 물가연동제라고 한다. For example, the increase in the CPI automatically determines the COLA in many multi-year labor contracts the adjustments in Social Security payments and federal income tax brackets MEASURING THE COST OF LIVING 27

Correcting Variables for Inflation: Real vs. Nominal Interest Rates The nominal interest rate: the interest rate not corrected for inflation the rate of growth in the dollar value of a deposit or debt 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) MEASURING THE COST OF LIVING 28

Correcting Variables for Inflation: Real vs. Nominal Interest Rates Example: Deposit $1,000 for one year. Nominal interest rate is 9%. During that year, inflation is 3.5%. Real interest rate = Nominal interest rate – Inflation = 9.0% – 3.5% = 5.5% The purchasing power of the $1000 deposit has grown 5.5%. MEASURING THE COST OF LIVING 31 29

Real and Nominal Interest Rates in the U.S., 1950-2007 This graph replicates Figure 3 from this chapter. The figure is constructed using quarterly data from the U.S. The nominal interest rate is the rate on a three-month Treasury Bill. The real interest rate is the same, minus the inflation rate as measured by the percentage change in the CPI. Notice that the nominal and real interest rates often do not move together, indicating that the real interest rate varies over time. Sources: CPI – Bureau of Labor Statistics Treasury bill rate – Board of Governors of the Federal Reserve System. I obtained both from the Federal Reserve Bank of St. Louis “Fred” database: http://research.stlouisfed.org/fred2/ MEASURING THE COST OF LIVING 30

CHAPTER SUMMARY The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer’s “basket” of goods & services. The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation. The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate. 31