Inflation impacts our daily lives, affecting how much we pay for goods and services. The Consumer Price Index (CPI) helps measure these price changes by tracking a fixed basket of items over time. Understanding how the CPI is calculated gives us insight into inflation rates and economic trends.

Economists use various tools to measure price changes accurately. They account for biases in the CPI, like substitution and quality improvements. Other indices, such as the Producer Price Index and GDP deflator, provide additional perspectives on price changes throughout the economy.

Measuring Changes in the Cost of Living

Calculation of inflation rates

• Consumer Price Index (CPI) measures average change in prices paid by urban consumers for goods and services
  • Market basket is a fixed set of consumer goods and services used to track price changes over time (food, housing, transportation)
  • Also known as a basket of goods, representing typical consumer purchases
  • Reference base period is the time period against which prices are compared, with CPI set to 100 for the base period (1982-1984)
• Calculate CPI for a given year using the formula: $CPI = \frac{Cost \space of \space market \space basket \space in \space given \space year}{Cost \space of \space market \space basket \space in \space base \space period} \times 100$
• Inflation rate measures the percentage change in the price index from one period to another
  • Calculate inflation rate using the formula: $Inflation \space rate = \frac{CPI_{current \space year} - CPI_{previous \space year}}{CPI_{previous \space year}} \times 100$
  • Example: If CPI increased from 200 to 210, inflation rate would be $\frac{210 - 200}{200} \times 100 = 5%$

Minimizing CPI biases

• Substitution bias occurs when consumers substitute away from goods that become relatively more expensive (chicken for beef)
  • Bureau of Labor Statistics (BLS) addresses this by updating the market basket periodically to reflect changes in consumer spending patterns
• Quality bias arises when improvements in product quality are not fully accounted for in the CPI (faster computers at same price)
  • BLS makes adjustments for changes in product quality to minimize this bias
• New product bias happens when new products are not included in the CPI immediately (smartphones in early 2000s)
  • BLS regularly updates the market basket to include new products and capture their price changes
• Outlet bias occurs when shifts in consumer purchases from high-cost to low-cost outlets are not captured (shopping at discount stores)
  • BLS samples prices from a variety of outlets, including discount stores and online retailers, to minimize this bias

Price indices for economic measurement

• Consumer Price Index (CPI) measures changes in prices of goods and services purchased by households
  • Covers a broad range of consumer goods and services (food, housing, apparel, transportation, medical care, recreation)
  • Does not include prices of imported goods or goods produced for export
• Producer Price Index (PPI) measures changes in prices received by domestic producers for their output
  • Covers raw materials, intermediate goods, and finished goods (crude oil, lumber, tires, computers)
  • Does not include prices of imported goods
  • Used to predict future changes in the CPI, as changes in producer prices often lead to changes in consumer prices
• GDP deflator measures changes in prices of all goods and services produced within a country's borders
  • Includes prices of exported goods but not imported goods
  • Covers a broader range of goods and services than CPI or PPI (government services, capital goods)
  • Not based on a fixed market basket; weights change as composition of GDP changes over time

Cost of Living and Purchasing Power

• Cost of living refers to the amount of money needed to maintain a certain standard of living
• Price level is the average of current prices across the entire spectrum of goods and services
• Real income is income adjusted for changes in the price level, reflecting purchasing power
• Purchasing power is the amount of goods and services that can be bought with a unit of currency
• Indexation is the practice of adjusting wages or other payments based on changes in a price index to maintain purchasing power