Inflation Module 15

Measuring the Cost of
Living
Copyright © 2001 by Harcourt, Inc.
All rights reserved. Requests for permission to make copies of any part of
the
work should be mailed to:
Permissions Department, Harcourt College Publishers,
Measuring the Cost of Living
 Inflation refers to a situation in which the

economy’s overall price level is rising.
 The inflation rate is the percentage
change in the price level from the
previous period.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Using Price Indexes
 Because inflation may overstate the value
of our GDP we need to make adjustments
accordingly.
 A price index is a measurement of how
the average price of a standard group of
goods changes over time.
 Price indexes are the way we adjust
nominal GDP (the value of GDP in
current dollars) to real GDP (the value of
GDP in constant dollars)
Consumer Price Index
 The consumer price
index (CPI) is a measure
of the overall cost of the
goods and services
bought by a typical
consumer.
 The consumer price
index uses a “fixed
basket of goods” and
evaluates changes in the
basket’s costs each
month.
Calculating a Price Index
Price Index in given year =
Cost of market basket in a given year X 100
Cost of market basket in base year
The Bureau of Labor Statistics reports the CPI each month
Current changes in the CPI
Does the CPI overstate Inflation?
 Two reasons why it might:
 The CPI uses a fixed basket of goods. If the price
of a good in the basket rises, the CPI rises. In
reality, if the price of a good rises consumers
typically substitute in a cheaper good.
 The CPI does not take into account the value of
innovation and the improvements in technology we
enjoy. A $2000 computer from 1990 is not the
same as a $2000 computer today.
Other Price Indexes
 The BLS calculates other prices indexes:
 The indices for different regions within the
country.
 The producer price index, which measures the cost

of a basket of goods and services bought by firms
rather than consumers. This index is a leading
indicator of future price increases for consumers.
 The GDP deflator
The GDP deflator allows us to distinguish
between nominal GDP, which
measures prices and quantities, and real
GDP, which measures just quantities.
The GDP deflator is calculated as follows:
Nominal GDP
GDP deflator =  100
Real GDP
How the Consumer Price Index Is Calculated
1. Fix the Basket: Determine what

prices are most important to the
typical consumer.
2. Find the Prices: Find the prices of
each of the goods and services in the
basket for each point in time.
3. Compute the Basket’s Cost: Use the
data on prices to calculate the cost of
the basket of goods and services at
different times.
How the Consumer Price Index Is
Calculated
4. Choose a Base Year and Compute the Index:
 Designate one year as the base year, making
it the benchmark against which other years

are compared.
 Compute the index by dividing the price of
the basket in one year by the price in the

base year and multiplying by 100.
Current prices x 100 = CPI
Base prices
The Inflation Rate
 We use the Consumer Price Index to calculate the
inflation rate.
 Compute the inflation rate: The inflation rate is
the percentage change in the price index from the
preceding period.
CPI in Year 2 - CPI in Year 1
Inflation Rate in Year2   100
CPI in Year 1
Causes of inflation
 Demand Pull Theory – demand for
goods & services exceeds existing
supply. One reason for this may be
too much money in circulation.
 Cost Push Theory- producers raise
prices in order to meet increased
costs. This is also known as supply
shocks (supply curve shifts left).
Demand-pull Cost-push or Supply
Shock
AS2
P P AS1
R R
I AS
I
C C
E E
L L
E E
V V
E E
L AD1 AD2 L AD
REAL GDP REAL GDP
Effects of Inflation
Interest Rates:
•Interest represents a payment in the
future for a transfer of money in the
past.
•When you save or loan someone
money you expect a return on that
money (interest).
•Inflation affects the future value of
our money.
Real and Nominal Interest Rates
 The nominal interest rate is the interest
rate not corrected for inflation.
 It is the stated interest rate that a bank pays.
 The real interest rate is the nominal
interest rate that is corrected for
inflation. When evaluating your return
you need to focus on the real interest rate
Real interest rate = (Nominal interest rate –
Inflation rate)
 You borrowed $1,000 for one year.

 Nominal interest rate was 15%.
 During the year inflation was 10%.
Real interest rate = Nominal interest rate – Inflation
= 15% - 10% = 5%
Anticipated and Unanticipated
Inflation
 If a bank anticipates inflation they will
set the nominal rate high enough to
insure a return on any loans they make
and inflation will not harm them.
 If inflation is unanticipated then the
interest rate will not be set high enough
and the bank (savers) will lose money.
Interest Rates
(percent per
year)
15
Nominal
interest rate
10
Real interest rate

-5
1965 1970 1975 1980 1985 1990 1995 1998
Who’s Hurt? Who’s Helped?
By Unanticipated Inflation
You’re hurt if you are a You’re helped if you are a
 Creditor – the money  Borrower- the money you
you loan out is worth less are repaying is worth less

when its paid back  Flexible income earner-
 Saver – inflation rates  if your income is tied to
are normally higher than profits you will earn more
interest rates  If your income is adjusted
 Fixed income receiver- a
for inflation you will earn
more (COLA)
constant income will buy  Payer of fixed amounts
less.

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Measuring the Cost of

Copyright © 2001 by Harcourt, Inc.

 Inflation refers to a situation in which the

 The producer price index, which measures the cost

 The GDP deflator

The GDP deflator is calculated as follows:

1. Fix the Basket: Determine what

it the benchmark against which other years

the basket in one year by the price in the

REAL GDP REAL GDP

 You borrowed $1,000 for one year.

Real interest rate

you loan out is worth less are repaying is worth less

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