Chapter 24MP 13-14 2s

In this chapter,
look for the answers to these questions:
Lecture 16
What is the Consumer Price Index (CPI)?

How is it calculated? Whats it used for?
What are the problems with the CPI? How

serious are they?
24
How does the CPI differ from the GDP deflator?

How can we use the CPI to compare dollar
Measuring the Cost of

Living
amounts from different years? Why would we

want to do this, anyway?
How can we correct interest rates for inflation?

1
The Consumer Price Index (CPI)
How the CPI Is Calculated
The consumer price index (CPI) is a measure of the

overall cost of the goods and services bought by a
typical consumer. The National Statistics
Coordination Board (NSCB) reports the CPI each
month.
It is used to monitor changes in the cost of living
over time. When the CPI rises, the typical family has
to spend more pesos to maintain the same standard
of living.
It is the basis of cost of living adjustments (COLAs)
in many contracts and in Social Security
Inflation refers to a situation in which the economys
overall price level is rising. The inflation rate is the
percentage change in the price level from the
previous period.
1. Fix the basket.

The National Statistical Coordination Board
(NSCB) surveys consumers to determine
whats in the typical consumers shopping
basket.
2. Find the prices.
The NSCB collects data on the prices of all the
goods in the basket.
3. Compute the baskets cost.
Use the prices to compute the total cost of the
basket.
Whats in the CPIs Basket?
Philippines: Whats in the CPIs Basket?
Food and bev.
2009 Consumer Price Index components
7.1%
16.9%
Housing
3.2%
Apparel
Transportation
Services
16%
Fuel, Light and

Water
7%
Housing and
Repairs
17%
Miscellaneous
Items
7%
6.0%
3.6%
3.6%
3.4%
Medical care
Food,
Beverage &
Tobacco
50%
Recreation
15.3%
Education
Communication
Clo th ing
3%
Other goods
and services
4
41.0%
5
EXAMPLE
How the CPI Is Calculated

4. 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
5. Compute the inflation rate.

The percentage change in the CPI from the
preceding period.
Inflation
=
rate
CPI this year CPI last year

CPI last year
basket: {4 pizzas, 10 lattes}
year
price of
pizza
price of
latte
2010
$10
$2.00
$10 x 4 + $2 x 10
2011
$11
$2.50
$11 x 4 + $2.5 x 10 = $69
2012
$12
$3.00
$12 x 4 + $3 x 10
cost of basket
= $60
= $78
Compute CPI in each year using 2010 base year:

Inflation rate:
115 100
x 100%
100
130 115
x 100%
13% =
115
2010: 100 x ($60/$60) = 100
15% =
2011: 100 x ($69/$60) = 115

x 100%
2012: 100 x ($78/$60) = 130
ACTIVE LEARNING
ACTIVE LEARNING
Calculate the CPI

CPI basket:
{10 lbs beef,
20 lbs chicken}
The CPI basket cost $120

in 2010, the base year.
price price of
of beef chicken
2010
$4
$4
2011
$5
$5
2012
$9
$6
Answers
1
price price of
of beef chicken
CPI basket:
{10 lbs beef,
20 lbs chicken}
2010
$4
$4
2011
$5
$5
2012
$9
$6
A. Compute the CPI in 2011:
A. Compute the CPI in 2011.

B. What was the CPI inflation rate from 20112012?
Cost of CPI basket in 2011

= ($5 x 10) + ($5 x 20) = $150
CPI in 2011 = 100 x ($150/$120) = 125
ACTIVE LEARNING
Answers
CPI basket:
{10 lbs beef,
20 lbs chicken}
ACTIVE LEARNING
price price of
of beef chicken
2010
$4
$4
2011
$5
$5
2012
$9
$6
B. What was the inflation rate from 20112012?
Cost of CPI basket in 2012

= ($9 x 10) + ($6 x 20) = $210
CPI in 2012 = 100 x ($210/$120) = 175
CPI inflation rate = (175 125)/125 = 40%
Substitution bias
CPI basket:
{10# beef,
20# chicken}
In 2010 and 2011,
households
bought CPI basket.
beef chicken
cost of CPI
basket
2010
$4
$4
$120
2011
$5
$5
$150
2012
$9
$6
$210
In 2012, households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2012 household basket.
B. Compute % increase in cost of household basket
over 201112, compare to CPI inflation rate.
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ACTIVE LEARNING
Answers
CPI basket:
{10# beef,
20# chicken}
Household
basket in 2012:
{5# beef,
25# chicken}
ACTIVE LEARNING
Answers
beef chicken
cost of CPI
basket
2010
$4
$4
$120
2011
$5
$5
$150
2012
$9
$6
$210
CPI basket:
{10# beef,
20# chicken}
beef chicken
Household
basket in 2012:
{5# beef,
25# chicken}
cost of CPI
basket
2010
$4
$4
$120
2011
$5
$5
$150
2012
$9
$6
$210
B. Compute % increase in cost of household basket

over 201112, compare to CPI inflation rate.
A. Compute cost of the 2012 household basket.
($9 x 5) + ($6 x 25) = $195
Rate of increase: ($195 $150)/$150 = 30%

CPI inflation rate from previous problem = 40%
Problems with the CPI:
Problems with the CPI
Substitution Bias: over time, some prices rise faster than

others.
Unmeasured Quality Change: Improvements in the quality of

goods in the basket increase the value of each dollar.
Consumers substitute toward goods that become relatively

cheaper, mitigating the effects of price increases.
The CPI misses this substitution because it uses a fixed
basket of goods. Thus, the CPI overstates increases in the
cost of living.
The NSCB tries to account for quality changes

but probably misses some, as quality is hard to measure.
Thus, the CPI overstates increases in the cost of living.
The introduction of new goods increases variety, allows

consumers to find products that more closely meet their
needs.
In effect, dollars become more valuable.
Each of these problems causes the CPI to overstate cost of

living increases.
The CPI misses this effect because it uses a fixed basket of

goods. Thus, the CPI overstates increases in the cost of living.
The NSCB has made technical adjustments, but the CPI

probably still overstates inflation by about 0.5 percent per
year.
This is important because Social Security payments and
many contracts have COLAs tied to the CPI.
14
Two Measures of Inflation, 19602012
15
Philippines: Two Measures of Inflation
15
180
10
160
152.3
146.0
140
120
174.1
166.6
166.0
161.6
156.1
146.8
136.9
135.9
124.7
117.8
108.0
123.0
115.8
107.6
100.0
90.9
85.1
100.0
92.3
86.3
100
79.5
80
CPI
GDP deflator
78.8
67.7
60
54.9
59.9
40
20
00
98
96
94
92
90
88
02
20
20
19
19
19
CPI
19
GDP deflator
19
-5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
19
Percent change per year
200
17
Contrasting the CPI and GDP Deflator

Imported consumer goods:
included in CPI
excluded from GDP deflator
Correcting Variables for Inflation:

Comparing Peso/Dollar Figures from Different Times
Inflation makes it harder to compare dollar

amounts from different times.
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.
Example: the minimum wage

Php115 in Dec 1964
Php725 in Dec 2013
Did min wage have more purchasing power in
Dec 1964 or Dec 2013?
To compare, use CPI to convert 1964 figure into
2013 pesos
18
19
Comparing Peso/Dollar Figures from Different Times

Comparing Dollar Figures from Different Times

Amount
in todays =
dollars
Amount
in year T
dollars
Researchers, business analysts, and policymakers

often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar
(real) figures.
Price level today

Price level in year T
In our example,
year T is 12/1964, today is 12/2013
Min wage was Php 115 in year T
CPI = 31.3 in year T, CPI = 220.3 today
They can then see how a variable has changed

over time after correcting for inflation.
Example: the minimum wage
The minimum wage

220.3
in 1964 was Php809 Php809 = Php115 x 31.3
in todays (2013) pesos.
20
ACTIVE LEARNING
21
ACTIVE LEARNING
Comparing tuition increases
Answers
Tuition and Fees at Colleges and Universities

CPI
1990
2013
% change
130.7
218.1
66.9%
1990
2013
Private non-profit 4-year
Php9,340
Php27,293

(current Php)
Php9,340 Php27,293
Public 4-year
Php1,908
Php7,605
Php15,586 Php27,293
Public 2-year
Php906
Php2,713

(2013 Php)
130.7
218.1
Public 4-year (current Php)
Php1,908 Php7,605
Public 4-year (2013 Php)
Php3,184 Php7,605
CPI
Instructions: Express the 1990 tuition figures in 2013

dollars, then compute the percentage increase for all
three types of schools. Which type experienced the
largest increase in real tuition costs?
Public 2-year (current Php)

Public 2-year (2013 Php)
Php906
75.1%
138.9%
Php2,713
Php1,512 Php2,713
79.4%
23

Indexation

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
A dollar amount is indexed for inflation

if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI automatically
determines
the COLA in many multi-year labor contracts
adjustments in Social Security payments and
national income tax brackets
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)
24
25
Philippines: Real and Nominal Interest Rates

Real vs. Nominal Interest Rates
Interest Rates
(percent
per year)
15
Example:
Deposit Php1,000 for one year.
Nominal interest rate is 9%.
10
During that year, inflation is 3.5%.

Real interest rate
= Nominal interest rate Inflation
= 9.0% 3.5% = 5.5%
Nominal interest rate
The purchasing power of the $1000 deposit

has grown 5.5%.
Real interest rate

5
26
Real and Nominal Interest Rates in the U.S.,

19502012
1965
1970
1975
Interest rate
(percent per year)
1985
1990
1995
2000
27
CONSUMER PRICE INDEX FOR ALL INCOME

HOUSEHOLDS AND HEADLINE INFLATION RATES
Philippines
15
1980
Period
Index for All

Items
National Capital Region
Inflation
Rate1 (%)
Areas Outside NCR
Index for All Inflation Index for All

Items
Rate1 (%)
Items
10
Inflation
Rate1 (%)
2006=100
-5
-10
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Nominal
Real
2014
January
2013
December
137.7
134.0
136.8
4.2
3.0
4.1
129.2
126.4
128.6
2.7
1.6
2.6
140.3
136.3
139.4
4.6
3.3
4.6
November
135.8
3.3
127.9
1.9
138.3
3.8
October
135.2
2.9
126.8
1.1
137.8
3.4
September
135.0
2.7
126.9
1.1
137.5
3.1
August
July
June
May
April
March
February
134.2
133.9
133.7
132.0
132.8
132.5
132.4
2.1
2.5
2.8
2.6
2.6
3.2
3.4
126.3
126.2
126.2
125.7
125.6
125.5
125.7
-0.1
1.0
1.6
1.8
1.7
1.9
2.3
136.7
136.3
136.0
135.2
135.0
134.7
134.5
2.7
2.9
3.0
2.9
2.8
3.6
3.7
January
2012
132.1
130.1
3.0
3.2
125.8
124.4
2.4
2.9
134.0
131.9
3.3
3.2
29
CORE INFLATION RATE, PHILIPPINES

Month
2014
2013
2012
2011
2010
2011
SUMMARY
2010 2009 2008 2007 2006 2005 2004 2003
2006=100
2000=100
Average
2.9
3.7
4.3
3.6
3.6
3.7
4.1
6.2
2.8
5.5
7.0 5.7
3.4
December
3.2
3.3
4.2
3.7
3.4
3.4
3.2
7.3
2.6
4.6
5.9 r 7.8
3.8
November
2.8
3.4
4.5
3.7
3.7
3.5
2.7
7.9
2.3
4.7
6.1 7.6
3.9
October
2.5
3.6
4.7
3.4
3.9
3.3
2.7
7.8
2.4
5.1
6.3 6.9
3.8
September
2.3
3.8
4.5
3.7
3.5
3.8
2.8
7.5
2.7
5.0
6.5 6.6
3.9
August
1.9
4.3
4.3
4.0
3.4
4.2
2.9
7.0
2.9
5.3
6.6 6.4
3.7
July
2.3
4.1
4.5
3.7
3.7
3.9
3.6
6.3
3.0
5.4
6.8 6.2
3.6
June
2.9
3.7
4.7
3.6
4.0
3.8
3.9
6.6
2.5
5.8
7.1 5.3
3.2
May
3.0
3.7
4.4
3.5
3.7
3.9
4.4
6.2
2.6
6.1
7.6 4.7
2.5
April
3.1
3.6
4.0
3.8
3.3
4.0
5.0
5.9
2.6
6.3
7.8 4.3
2.6
March
3.9
3.0
4.3
3.6
3.5
3.8
5.6
4.8
2.6
6.5
8.0 4.3
2.4
February
3.8
3.2
4.2
3.4
3.5
3.6
6.4
4.0
3.0
6.3
8.1 4.1
2.9
3.6
4.3
3.7
2.9
3.3
3.0
6.9
3.4
3.9
5.7 r
7.9 4.1
2.9
January
3.2
The Consumer Price Index is a measure of the

cost of living. The CPI tracks the cost of the
typical consumers 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.
30

Chapter 24MP 13-14 2s

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Chapter 24MP 13-14 2s

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In this chapter,

look for the answers to these questions:

What is the Consumer Price Index (CPI)?

What are the problems with the CPI? How

How does the CPI differ from the GDP deflator?

Measuring the Cost of

amounts from different years? Why would we

How can we correct interest rates for inflation?

The Consumer Price Index (CPI)

How the CPI Is Calculated

The consumer price index (CPI) is a measure of the

1. Fix the basket.

Whats in the CPIs Basket?

Philippines: Whats in the CPIs Basket?

Food and bev.

2009 Consumer Price Index components

Fuel, Light and

How the CPI Is Calculated

cost of basket in current year

5. Compute the inflation rate.

CPI this year CPI last year

basket: {4 pizzas, 10 lattes}

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

Compute CPI in each year using 2010 base year:

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

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

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

Calculate the CPI

The CPI basket cost $120

A. Compute the CPI in 2011:

A. Compute the CPI in 2011.

Cost of CPI basket in 2011

B. What was the inflation rate from 20112012?

Cost of CPI basket in 2012

In 2012, households bought {5 lbs beef, 25 lbs chicken}.

B. Compute % increase in cost of household basket

A. Compute cost of the 2012 household basket.

($9 x 5) + ($6 x 25) = $195

Rate of increase: ($195 $150)/$150 = 30%

Problems with the CPI:

Problems with the CPI

Substitution Bias: over time, some prices rise faster than

Unmeasured Quality Change: Improvements in the quality of

Consumers substitute toward goods that become relatively

The NSCB tries to account for quality changes

The introduction of new goods increases variety, allows

Each of these problems causes the CPI to overstate cost of

The CPI misses this effect because it uses a fixed basket of

The NSCB has made technical adjustments, but the CPI

Two Measures of Inflation, 19602012

Philippines: Two Measures of Inflation

Percent change per year

Contrasting the CPI and GDP Deflator

Correcting Variables for Inflation:

Inflation makes it harder to compare dollar

Example: the minimum wage

Comparing Peso/Dollar Figures from Different Times

Correcting Variables for Inflation:

Correcting Variables for Inflation:

Researchers, business analysts, and policymakers

Price level today

They can then see how a variable has changed

The minimum wage

Comparing tuition increases