Cost of Living

Consumer Price Index (CPI)

This is a statistic which measures the overall cost of all goods and services bought by a typical consumer. CPI can be used to compute inflation and compare the standards of living at two different points of time. The inflation rate calculated by CPI is more representative of the economy than the rate calculated by GDP Deflator. Thus, when we say “Inflation”, we usually refer to “Inflation computed using CPI”.

Calculating CPI

1. Fix Basket of a Typical Consumer

   The “basket” refers to the goods and services that a typical consumer purchases. This basket is assumed to be fixed across the times of computation, and is obtained by surveying people.

2. Find Prices

   Find the prices of all the items in the basket at different years.

3. Compute Basket price

   Use the prices obtained to compute the cost of the basket. Again, we assume the basket to be fixed across the computation time.

4. Choose a Base Year and compute CPI

   Set an year as the base year for comparisons, and calculate the CPI for the remaining years by taking the ratio of the basket prices. \(\text{CPI in Year X} = \frac{\text{Basket Price in Year X}}{\text{Basket Price in Base Year}}\times 100\)

5. Compute Inflation Rate

   Similar to GDP Deflator, the Inflation rate between two years is calculated as the percentage change in the CPI between those two years. \(\text{Inflation Rate in Year2} = \frac{\text{CPI in Year2} - \text{CPI in Year1}}{\text{CPI in Year1}}\times 100\)

Core CPI - A measure of CPI excluding food and energy. This is because food and energy tend to be very variable, and core CPI better reflects inflation trends.

PPI - Stands for Producer Price Index. This computes the change in prices of the producers. Because an increase in PPI would ultimately lead to higher prices, this statistic can be used to predict changes in CPI.

PMI - Stands for Purchasing Manager Index. This computes the change in production of a factory/company on a monthly basis. >50 implies expansion and <-50 implies contraction.

WPI - Wholesale Price Index. CPI >= WPI as not all goods are considered on WPI.

Problems with CPI

CPI assumes that the basket of consumers remains the same across years, which need not be the case practically. Some of the problems caused due to this are discussed below.

• Substitution Bias - Increment in the price of a good in the basket would cause consumers to buy less of that good, and more of a substitute. This change is not reflected in the calculations.
• Introduction of New goods - Developments in technology can cause the introduction of new goods which might bring the CPI down. However, this would not happen unless the basket of the consumers is changed (which is a problem).
• Change in Quality of Goods - An already present good might be improved by the producer, which would have to decrease the CPI. This is not fully represented by the change in price, as there is an increase in the quality as well. We can try to decrease the price accordingly by measuring the value added, but measuring “value” is vague and difficult.

GDP Deflator and CPI comparison

The inflation rates calculated by both these terms are obviously not the same. The key difference is that the GDP deflator takes into account all the domestic-produced goods whereas the CPI takes what the consumers purchase into account. Therefore, if there is an increase in the price of imported goods, the GDP deflator is unchanged but the CPI increases.

Another subtle difference is that the basket is fixed for CPI, but the goods produced by producers in a country can be variable. Thus, the GDP deflator is more flexible to changes in goods over time.

Correcting Economic Terms for effects of Inflation

1. Comparing money from different times

\[\text{Amount Today} = \text{Amount in Year T} \times \frac{\text{Price Index Today}}{\text{Price Index at Year T}}\]

The CPI is usually used as the price index.

1. Regional Price Parities

The difference in the cost of living between different areas is represented by Regional Price Parity. The difference in prices is due to services, because relocating services is difficult. Housing services are an exceptionally good example.

1. Indexation

Contracts which are legally bound for large periods of time where are usually indexed. That is, the monetary exchange is corrected automatically based upon a statistic such as CPI.

1. Nominal and Real interest rates

Nominal interest rate is what the bank offers, without accounting for inflation. Taking inflation into account, the Real interest rate is calculated as follows:

\[\text{Real Interest Rate} \approx \text{Nominal Interest Rate} - \text{Inflation Rate}\]