Tuesday

 

Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 8 The Data of Macroeconomics
Chapter 24 of 36 Measuring The Cost of Living
Section 1 of 15
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Chapter 24 - Measuring the Cost of Living - Topics
· How the Consumer Price Index is Calculated
· Problems in Measuring the Cost of Living
· Accounting for Quality Change
· The GDP Deflator Versus the Consumer Price Index
· Correcting Economic Variables for the Effects of Inflation
· Real and Nominal Interest Rates
· Interest Rates in the U.S. Economy
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Grok summary of Chapter 24: Measuring the Cost of LivingThis chapter explains how economists measure the cost of living and inflation using the Consumer Price Index (CPI), the most widely reported price index.

The CPI tracks the cost of a fixed basket of goods and services bought by a typical consumer.
It is calculated in five steps:
⦁ fix the basket based on consumer surveys,
⦁ find current prices each month
⦁ compute the total cost of the fixed basket
⦁ set the base-year cost equal to 100 to create the index
⦁ calculate the inflation rate as the percentage change in the CPI from one year to the next
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Although useful, the CPI has three important problems that cause it to overstate the true rise in the cost of living:
⦁ substitution bias — consumers switch to cheaper goods when prices change, but the fixed basket does not
⦁ introduction of new goods — new products improve living standards before they are added to the basket
⦁ unmeasured quality changes — improvements in goods are often missed, so price increases look like pure inflation
These biases are estimated to overstate inflation by about 1 percentage point per year.
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The chapter compares the CPI with the GDP deflator.
⦁ the CPI uses a fixed consumer basket including imports
⦁ the GDP deflator reflects the prices of all goods and services produced domestically
They usually move together but can diverge when import prices or capital-goods prices change sharply.
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Finally, the chapter shows how to correct economic variables for inflation by converting nominal (face value dollar) amounts to real (constant dollar value) amounts using the CPI ratio.
It also introduces:
⦁ indexation — automatic inflation adjustments
⦁ the difference between nominal interest rates and real (inflation-adjusted) interest rates
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Key takeaways:
The Consumer Price Index is the main tool for tracking the cost of living, but it is imperfect.
We must always adjust dollar figures across time for inflation to understand real changes in living standards.
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consumer price index
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