MEASURING THE COST OF LIVING

Introduction

Few years after the independence of Tunisia, the income per capita was around 50 TD. Today, it is well over 5000 TD.

To compare the two figures, we need to find some way of turning dollar figures into meaningful measures of purchasing power.

That is exactly the job of a statistic called the consumer price index (CPI).

The CPI is used to monitor changes in the cost of living over time. When the CPI rises, the typical family has to spend more to maintain the same standard of living.

Inflation describes a situation in which the economy’s overall price level is rising.   Economists measure the inflation rate by the consumer price index.

THE CONSUMER PRICE INDEX

The CPI is a measure of the overall cost of the goods and services bought by a typical consumer.

The first step in computing the CPI is to determine which prices are most important to the typical consumer.

If the typical consumer buys more of good A than good B,  then the price of  A  is more important than the price of  B and, therefore, should be given greater weight in measuring the cost of living.

The INS sets the weights by surveying consumers and finding the basket of goods and services that the typical consumer buys.

CALCULATING THE CPI AND THE INFLATION RATE:

STEP 1: SURVEY CONSUMERS TO DETERMINE A FIXED BASKET OF GOODS.

STEP 2: FIND THE PRICE OF EACH GOOD IN EACH YEAR.

STEP 3: COMPUTE THE COST OF THE BASKET OF GOODS IN EACH YEAR.

STEP 4: CHOOSE ONE YEAR AS A BASE YEAR AND COMPUTE THE CPI IN EACH YEAR.

STEP 5: USE THE CPI TO COMPUTE THE INFLATION RATE FROM PREVIOUS YEAR.

What is in the CPI’s Basket?

INS tries to include all the goods and services that the typical consumer buys.

Moreover, it tries to weight these goods and services according to how much consumers buy of each item.

PROBLEMS IN MEASURING THE COST OF LIVING

The goal of the CPI is to measure changes in the cost of living. It tells how much incomes must rise in order to maintain a constant standard of living.  Three problems with the index:

Substitution bias:

Prices do not change proportionately.  Consumers respond by buying less of the goods whose prices have risen by large amounts and more of the goods whose prices have raised less. The assumption of a fixed basket of goods leads to an overestimation of the increase in the cost of living.

Introduction of new goods:

 Consumers have more variety from which to choose. Greater variety, in turn, makes each dollar more valuable... Yet because the consumer price index is based on a fixed basket, it does not reflect this change in the purchasing power.

Unmeasured quality change:

if the quality rises from one year to the next, the value of a dollar rises.

THE GDP DEFLATOR VERSUS THE CONSUMER PRICE INDEX

The GDP deflator is the ratio of nominal GDP to real GDP. The GDP deflator reflects the current level of prices relative to the level of prices in the base year.

Economists and policymakers monitor both the GDP deflator and the CPI to estimate how quickly prices are rising.

Usually, these two statistics tell a similar story. Yet there are two important differences that can cause them to diverge.

GDP deflator reflects the prices of all goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers.

The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year.  By contrast, the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year.

The two measures of inflation generally move together

INDEXATION

Indexation: 

Automatic correction of a dollar amount for the effects of inflation by law or contract.

Many long-term contracts between firms and unions include partial or complete indexation of the wage to the CPI. Such a provision is called a cost-of-living allowance. Wages are automatically raised   when the consumer price index rises.

REAL AND NOMINAL INTEREST RATES

The interest rate that the bank pays is called the nominal interest rate.

The interest rate corrected for inflation is called the real interest rate.

Real interest rate= Nominal interest rate - Inflation rate.

The nominal interest rate shows how fast the number of dinars in your bank account rises over time. The real interest rate tells you how fast the purchasing power of your bank account rises over time.

·        Real and nominal interest rates do not always move together.

Summary

The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year.

The index is used to measure the overall level of prices in the economy. The percentage change in the consumer price index measures the inflation rate.

The CPI is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers’ ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services.

Because of these measurement problems, the CPI overstates annual inflation.

Although the GDP deflator also measures the overall level of prices in the economy, it differs from the consumer price index because it includes goods and services produced rather than goods and services consumed.

As a result, imported goods affect the consumer price index but not the GDP deflator.

Whereas the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

Dinar figures from different points in time do not represent a valid comparison of purchasing power. To compare a dollar figure from the past to a dollar figure today, the older figure should be inflated using a price index.

Various laws and private contracts use price indexes to correct for the effects of inflation. A correction for inflation is especially important when looking at data on interest rates. The real interest rate equals the nominal interest rate minus the rate of inflation.