Chapter 25: The Cost of Living

11© 2014 by McGraw-Hill Education Chapter 25 The Cost of Living 2© 2014 by McGraw-Hill Education • What a market basket is and why it’s important. • How to calculate and use a price index. • How to identify challenges the Bureau of Labor Statistics (BLS) faces when measuring inflation. • How the BLS responds to these challenges. • How to calculate the inflation rate using three methods. • How to adjust nominal values into real values. • How to define and calculate purchasing power parity. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • A large focus of macroeconomics is prices, but more importantly how changes in prices impact how much we can buy. • Prices change at different speeds across time and place. • Changing prices have effects on people’s incentives and choices. – Price levels determine the relative value of salaries, savings and borrowing, and the relative cost of living in a different city. The cost of living 24© 2014 by McGraw-Hill Education • The prices of many different goods and services must be considered when comparing the cost of living across time and place. • The market basket is a list of specific goods and services in fixed quantities. – The goal is to use this to see how the cost of buying these goods and services changes over time and location. – Items typically purchased by individuals. – Keeping the quantities of each item constant ensures that changes only reflect price changes. The market basket 5© 2014 by McGraw-Hill Education • Consider changes in the prices of four items you typically buy at the grocery store. • How much did the cost of groceries rise between years? The market basket Quantity purchased Price last year ($) Price this year ($) Bread (per loaf) 1 3.00 3.15 Milk (per gallon) 1 2.50 2.55 Beef (per pound) 3 3.50 3.64 Carrots (per pound) 1 1.00 1.25 Total Cost2012 = ($3.00 x 1)+($2.50 x 1)+($3.50 x 3)+($1.00 x 1)= $17.00 Total Cost2013 = ($3.15 x 1)+($2.55 x 1)+($3.64 x 3)+($1.25 x 1) = $17.87 Price increase from 2012 to 2013 = [($17.87 - $17)/$17] x 100 = 5.1% 6© 2014 by McGraw-Hill Education Information for the market basket is listed in the table. Calculate the total cost for each year. Active Learning: Calculating total cost Year Quantity of Apples Quantity of Oranges Price of Apples ($) Price of Oranges($) 2012 3 5 1 1 2013 3 5 2 1 2014 3 5 3 2 Year Total Cost ($) 2012 2013 2014 37© 2014 by McGraw-Hill Education • A price index is a measure showing how much the cost of a market basket has changed relative to the cost in a base time period or location. – Base year index is equalized to 100. • The Consumer Price Index (CPI) is a measure that tracks changes in the cost of a basket of goods and services purchased by a typical U.S. household. – CPI is the most commonly used index tool for tracking changes in the cost of living in the U.S. – The CPI is tracked by the Bureau of Labor Statistics (BLS). Consumer price index 8© 2014 by McGraw-Hill Education • The CPI measures the increase in the cost of the market basket relative to the cost in a given base year. CPI = େ୭ୱ୲ ୭୤ ୢୣୱ୧୰ୣୢି୷ୣୟ୰ ୠୟୱ୩ୣ୲ ୧୬ ୠୟୱୣି୷ୣୟ୰ ୮୰୧ୡୣୱେ୭ୱ୲ ୭୤ ୠୟୱୣି୷ୣୟ୰ ୠୟୱ୩ୣ୲ ୧୬ ୠୟୱୣ ୷ୣୟ୰ ୮୰୧ୡୣୱ × 100 • By definition, the index always equals 100 in the base year. – The index will be greater than 100 if the cost of the basket is greater than the base-year cost. – The index will be less than 100 if the cost of the basket is less than the base-year cost. Consumer price index 9© 2014 by McGraw-Hill Education Information on total cost for each year is listed in the table. Calculate the CPI for the basket of goods in each year assuming that the base year is 2012. Active Learning: Calculating CPI Year Total Cost CPI 2012 $8 2013 $11 2014 $19 410© 2014 by McGraw-Hill Education The following illustrates the CPI from 1913 to 2011. Consumer price index 0 50 100 150 200 250 1910 1930 1950 1970 1990 2010 Consumer price index (1984 = 100) CPI Year 11© 2014 by McGraw-Hill Education • There are two main challenges. • Which goods should be included in the market basket? – A single number cannot perfectly describe changes in the cost of living for everyone. • The BLS tries to come up with a basket that represents a “typical” household. – The CPI basket is based on the average goods and services purchased by “urban consumers.” – One family’s cost of living could be different than that computed by the CPI -- depends on what they purchase. The challenges in measuring price changes 12© 2014 by McGraw-Hill Education • The chart below provides a snapshot of the current CPI’s basket. • Represents spending by urban consumers. The challenges in measuring price changes 4% 4% 6% 6% 7% 15% 17% 41% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% Other goods and services Apparel Recreation Education and communication Medical care Food and beverage Transportation Housing 513© 2014 by McGraw-Hill Education • The second challenge is that the basket of goods remains fixed even if consumers substitute between similar goods – If the relative price of goods changes, the quantities change as well. – As new goods and services become available (innovation), people will adjust what they consume. • The CPI keeps types and quantities of goods constant, which does not account for consumption changes. The challenges in measuring price changes 14© 2014 by McGraw-Hill Education • Similar to GDP, economic variables give an incomplete picture when expressed in nominal terms, as their real value may be different over time. • Price indices transform nominal values into real values. – Isolate changes in prices from changes in other economic variables, like income and output. Using price indices 15© 2014 by McGraw-Hill Education • The inflation rate is the size of the change in the overall price level. • It is calculated as the percentage change in the CPI from year to year: Inflation = ஼௉ூ೤೐ೌೝ మି஼௉ூ೤೐ೌೝ భ஼௉ூ೤೐ೌೝ భ × 100 The inflation rate 616© 2014 by McGraw-Hill Education The following table calculates the inflation rate. The inflation rate Year CPI Calculation Inflation rate (%) 2005 195.3 ——— 2006 201.6 201.6 - 195.3 195.3 x 100 3.2 2007 207.3 207.3 - 201.6 201.6 x 100 2.8 2008 215.3 215.3 - 207.3 207.3 x 100 3.8 2009 214.5 214.5 - 215.3 215.3 x 100 -0.4 2010 218.1 218.1 - 214.5 214.5 x 100 1.6 2011 224.9 224.9 - 218.1 218.1 x 100 3.1 • The CPI tells how much prices have changed from the base year prices (1984). • The inflation rate tells by how much prices have changed from year to year. • In 2009 the inflation rate was negative; deflation occurred. 17© 2014 by McGraw-Hill Education Calculate the inflation rates for 2013 and 2014 using the following information. Active Learning: Calculating inflation rates Year CPI Inflation Rate 2012 100 -- 2013 138 2014 238 18© 2014 by McGraw-Hill Education • There are several common ways to report inflation. • The CPI: – Headline inflation measures price changes for the entire market basket. – Core inflation measures price changes with food and energy costs removed. • Energy and food prices fluctuate often, which could over- or understate the real change in overall prices. • Producer price index (PPI) measures the prices of goods and services purchased by firms. • GDP deflator measures the prices of goods and services produced in the country. The inflation rate 719© 2014 by McGraw-Hill Education This graph provides the three common measures of inflation for the United States from 1960-2010. The inflation rate -10 -5 0 5 10 15 20 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Consumer price index GDP deflator Producer price index Percent change Year 20© 2014 by McGraw-Hill Education • The CPI (or another price index) can be used to “deflate” nominal values into real values. – Compares purchasing power over time. • Any nominal value in year X can be put into year Y value using: Real value୷ୣୟ୰ ଢ଼ = Nominal value୷ୣୟ୰ ଡ଼ × CPI୷ୣୟ୰ ଢ଼ CPI୷ୣୟ୰ ଡ଼ Deflating nominal variables 21© 2014 by McGraw-Hill Education This table provides the value of the top 20% earners for the last five decades in terms of the year 2000 prices. Deflating nominal variables Year Average income of top 20 percent ($) Value in 2009 dollars 1969 20,520 36.7 X 214.5 36.7 = 1979 43,265 72.6 X 214.5 72.6 = X 214.5 124.0 = X 214.5 166.6 = 2000 170,844 214.5 $170,844 $135,250 $ 85,529 $ 43,265 $ 20,520 $174,136 $147,951 $127,828 $119, 933 1999 135,250 124.0 CPI (1982 – 84 = 100) 166.6 85,5291989 • The average income of those living in 1969 looks much lower than in 2000. • Inflating 1969 nominal incomes to the year 2000 prices, the value of a dollar in each year is the same between the two decades. The gap decreases dramatically. 822© 2014 by McGraw-Hill Education Suppose a worker made $4.25/hour in 1993. How much is this worth today if the CPI in 1993 was 142 and today it is 216? Active Learning: Deflating nominal variables 23© 2014 by McGraw-Hill Education • A fundamental theory in macroeconomics states that wages should naturally rise to offset the effects of inflation. – However, there are times when some prices change faster than wages. • Indexing is a practice of automatically increasing payments in proportion to the cost of living. – These payments are often referred to as “cost-of- living adjustments.” Adjusting for inflation: Indexing 24© 2014 by McGraw-Hill Education While minimum wage has increased over time, the real value of minimum wage has fallen since the late 60s. Adjusting for inflation: Minimum wage Minimum wage Real wage 0 2 4 6 8 10 12 19 38 19 50 19 56 19 44 19 63 19 68 19 74 19 80 19 86 19 92 19 98 20 04 20 10 Dollars • The nominal minimum wage has steadily increased since the 1940s. • The real value has fluctuated as Congress has adjusted the nominal value to try to keep up with inflation. 925© 2014 by McGraw-Hill Education • Purchasing power parity (PPP) refers to the theory that purchasing power in different countries should be the same when stated in a common currency. • In reality, PPP almost never holds because of three main factors: Accounting for price differences across places Transaction costs Non-tradables Trade restrictions 26© 2014 by McGraw-Hill Education • Purchasing power indexes (PPIs) help describe differences in prices across locations. • Developing a purchasing power index is similar to creating a price index: 1. Find a market basket of foods and services to compare across countries. 2. Measure the price of the goods in each country. 3. Calculate the cost of purchasing the basket in each country. 4. Build an index showing how much the basket costs in each country relative to some base. Purchasing power indexes 27© 2014 by McGraw-Hill Education One example of a PPI is the Big Mac Index • Uses McDonald’s Big Mac as the basket. • Compares the price of a Big Mac in each country to the U.S. Purchasing power indexes 260 240 220 0 20 40 60 80 China Thailand Malaysia Russia Mexico South Africa South Korea Singapore Britain Japan Canada Euro area Brazil Switzerland Percent by which local currency is valued relative to the dollar United States 4.20 4.16 3.82 3.75 3.19 2.70 2.45 2.55 2.34 2.46 2.44 4.63 4.43 5.68 6.81 Big Mac price in $ Cost of living is higher than U.S. (Lower purchasing power of local currency per nominal dollar) Cost of living is lower than U.S. (Higher purchasing power of local currency per nominal dollar) 10 28© 2014 by McGraw-Hill Education • The PPP-adjustment recalculates economic statistics to account for differences in price levels across countries. • For example, to compare GDP across countries: PPI– adjusted GDP = Nominal dollarsୡ୭୳୬୲୰୷ ୅ × [ ଵ(ଵ ି ୔୰୧ୡୣ ୪ୣ୴ୣ୪ ୟୢ୨୳ୱ୲୫ୣ୬୲ ୡ୭୳୬୲୰୷ ୅ )] • The price level adjustment is the percentage difference in purchasing power between the two countries. PPP-adjustment 29© 2014 by McGraw-Hill Education Suppose Argentina has a GDP per capita of $10,942 USD and that the cost of living is 30.2% lower than the United States. What is the PPI- adjusted GDP for Argentina? Active Learning: Calculating PPI-adjusted GDP 30© 2014 by McGraw-Hill Education • Market baskets are defined to help understand how the overall cost of living has changed over time. – Holding goods and quantities constant isolates price changes. • Price indexes are constructed to help summarize changes in price levels. • The most commonly used price index is the CPI. Summary 11 31© 2014 by McGraw-Hill Education • The inflation rate describes the size of changes in the overall price level between years. • Price indexes allow us to determine the purchasing power of money from different time periods. • Purchasing power parity (PPP) is the idea that price levels in different countries should be the same once they are stated in a common currency. Summary 32© 2014 by McGraw-Hill Education • PPP does not always hold true because of transaction costs, non-tradables, and trade restrictions. • The BLS faces challenges with respect to what items to include in the basket and how to adjust for changes in consumption over time. • Economic variables are recalculated using a price index to account for differences in purchasing power across countries. Summary