Government, Business and

Society
Measuring Cost of Living

Module- 2
Macroeconomic Framework
Contents
National Income Analysis: Circular flow of Income,
Concepts of national income and measurement.
Consumption Function, Investment Function,
Concept of Multiplier and Accelerator, Aggregate
Demand & Aggregate Supply National Income
Equilibrium, Inflationary & Deflationary gaps, Real
Business cycles, Application of above in business
and society.

 How we calculate overall cost of living?

Converting monetary figures into meaningful
purchasing power
Consumer price index
Inflation describe a situation in which economys
overall price level is rising.
Inflation rate is percentage change in the price
level from previous period.

The Consumer Price Index

Consumer price index (CPI)
Measure of the overall level of prices
Measure of the overall cost of goods and
services
Bought by a typical consumer

Calculating CPI
1. Fix the basket
Which prices are most important to the typical
consumer
Different weight

2. Find the prices

At each point in time

3. Compute the baskets cost

By keeping same basket of goods effects of
price changes is isolated

Calculating CPI
4. Chose a base year and compute the index
Base year = benchmark
Price of basket of goods & services in current year
Divided by price of basket in base year
Times 100

5. Compute the inflation rate

Inflation rate in year 2 =

CPI in year 2 - CPI in year 1

100
CPI in year 1

Calculating the Consumer Price Index and the

Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation
rate for a hypothetical economy in which consumers buy only hot dogs and
hamburgers.

Calculating the Consumer Price Index and the

Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation
rate for a hypothetical economy in which consumers buy only hot dogs and
hamburgers.

The Typical Basket of Goods and Services

This figure shows how

the typical consumer
divides spending
among various
categories of goods
and services.
Economists calls each
percentage the relative
importance of the
category.

Inflation- Other measures

Producer price index, PPI

Measure of the cost of a basket of goods and services

bought by firms
Changes in PPI are often thought to be useful in
predicting changes in CPI

Wholesale price index, WPI

Captures the movements in the wholesale prices ; Very

close to the PPI
Differs from the PPI to the extent of tax, wholesale
margin and transport cost from manufacturing units to
wholesale establishment
Many countries have switched over from the WPI to PPI
Because the PPI can track price changes at primary and
intermediate stages before it gets built into the finished
goods stages

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Problems in measuring the cost of living

Substitution bias
Prices do not change proportionately
Consumers substitute toward goods that have
become relatively less expensive
Overstates the increase in cost of living from one year to
next

Introduction of new goods

More variety of goods

Unmeasured quality change

Changes in quality

12

GDP deflator versus CPI

GDP deflator
Ratio of nominal GDP to real GDP
Reflects prices of all goods & services produced
domestically
Compares the price of currently produced goods
and services to the price of the same goods and
services in the base year

CPI
Cost of the basket- Reflects prices of goods &
services bought by consumers
Compares price of a fixed basket of goods and
services to the price of the basket in the base year
13

Two Measures of Inflation

This figure shows the inflation ratethe percentage change in the level of
prices as measured by the GDP deflator and the consumer price index using
annual data since 1965. Notice that the two measures of inflation generally move
together.
14

Correcting Economic Variables

Dollar figures from different times
Amount in today's dollars =
Price level today
Amount in year T dollars
Price level in year T

Indexation

Automatic correction by law or contract

Of a dollar amount
For the effects of inflation
DA (Dearness allowance or Cost of living
allowance)
15

Real and Nominal Interest Rates

Nominal interest rate
Interest rate as usually reported
Without a correction for the effects of inflation

Real interest rate

Interest rate corrected for the effects of inflation

= Nominal interest rate Inflation rate

17

Interest rates in a typical Economy

Nominal interest rate
Always exceeds the real interest rate
Economy experiences rising consumer prices in
every year

Inflation is variable
Real and nominal interest rates do not always
move together

Periods of deflation
Real interest rate exceeds the nominal interest
rate
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Real and Nominal Interest Rates

This figure shows nominal and real interest rates using annual data since 1965. The
nominal interest rate is the rate on a 3-month Treasury bill. The real interest rate is the
nominal interest rate minus the inflation rate as measured by the consumer price index.
Notice that nominal and real interest rates often do not move together.
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Price Indices in India

20

Price Indices: Sources of Data, Base Year, Commodity Composition

and Method of Computation
WPI

Source/ Agency

Office of the
Economic
Advisor/ MOI
Method
Laspeyres
Weights allocated Wholesale
on the basis of
transactions
Weighting
diagram
Price Quotations
Nature of the
index
Current Base Year

Country-wide,
unique
Bulk transactions
Single, national
2004-05

No of items in 676
basket
Major
items i)Primary articles
covered
ii)Fuel,
power,
light & lubricants
iii)Manufactured
products

CPI-IW

Labour Bureau/
MOL

Weekly: Primary
articles and Fuel,
power, light &
lubricants;
Monthly: Overall
and all sub-heads

CPI-RL

CPI-Rural

Labour
Bureau/ MOL

Labour
Bureau/ MOL

CPI-Urban

CPI-Combined
(Rural +Urban)

CSO

Laspeyres
Consumer Expenditure Survey
First 1958-59
Latest: 2001

First 1956-57
First 1983
round
NSS
Latest: 1983
Latest 1983
Horizontal summation of weights of centre specific indices
61st

2001

1986-87

120-360

260

i)food
ii)Pan,
Supari, tobacco&
intoxicants
iii)
fuel&light
iv)
housing
v)
clothing, bedding
&
footwear
vi)miscellaneous

i i)food beverages & tobacco

ii)fuel & light iii) clothing,
bedding
&
footwear
iv)miscellaneous

i)food beverages
& tobacco ii)fuel
&
light
iii)
clothing, bedding
& footwear iv)
miscellaneous

600

1181

3 weeks

250

year

2004-05
n.a.

n.a.
i)food
beverages &
tobacco ii)fuel
& light iii)
clothing,
bedding
&
footwear iv)
housing
v)
miscellaneous
310
1491
1 month

Monthly

NAS, CSO

2010

225

GDP Deflators

Passche
Current
quantities

Purchase price paid by the consumers

Weighted average of the centre indices

No.
of 5,482
78
Centres/Quotatio
ns
Time Lag
2 weeks/ 1 month 1 month
Frequency

CPI-AL

All
All items included
in the GNP

Benchmark surveys
2 years
Yearly

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Price Indices in India

Uses of Price Indices

Users
Purpose

WPI

CPI

GDP Deflator

RBI, Planning Commission,

Other govt org
Deflating Macroeconomic
aggregates
Forecasting variables for
which prices are prime
indicators
Working out escalation
costs of projects

Govt, Pvt org,

NGOs
Social security and
welfare allowances
CPI(IW) : wage &
dearness
allowances of
workers &
CPI (RL) & CPI
(AL): Fixing
minimum wages
Dearness
Allowances

Researchers
Government

Main Use Estimation of Inflation

Deflating
Macroeconomic
Indicators

22

Price Indices in India

WPI Vs CPI
CPI IW

WPI
WPI (Overall): available on
monthly frequency
WPI (Primary Articles) and WPI
(Fuel Group) available at weekly
frequency
Lag of a fortnight
Computed on all India basis
Coverage of non- agriculture /
manufactured products is better
Wider coverage of commodities:
less volatile to relative price

Available at monthly
frequency
Lag of one month
Constructed for specific
centres
Some consumer services are
also included
Lesser coverage of
commodity: subject to higher
volatility

23

Price Indices in India

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