22.2 How to Measure Changes in the Cost of Living

The Consumer Price Index (CPI) measures how much the cost of living changes over time. It looks at the prices of things we buy regularly, like food and housing. The CPI helps us understand inflation and how it affects our wallets.

Economists use other tools too, like the Producer Price Index and GDP deflator. These help paint a fuller picture of price changes in the economy. They also work to fix problems with the CPI to make it more accurate.

Measuring Changes in the Cost of Living

Consumer Price Index (CPI)

• Measure of overall cost of goods and services bought by typical consumer
• Calculated by Bureau of Labor Statistics (BLS) using representative basket of goods and services
  • Basket includes food, clothing, shelter, transportation, medical care
  • Prices of items weighted according to importance in typical consumer's budget
• Used to measure inflation by comparing cost of basket in given year to cost in base year
  • Inflation rate calculated as percentage change in CPI from one period to another
  • Formula: $Inflation Rate = \frac{CPI_1 - CPI_0}{CPI_0} \times 100\%$, where $CPI_1$ is current period CPI and $CPI_0$ is base period CPI

Addressing Potential Biases

• Substitution bias
  • Occurs when consumers substitute cheaper goods for more expensive ones as prices rise (ground beef for steak)
  • Addressed by using chained CPI, accounts for changes in consumer behavior
• Quality bias
  • Occurs when quality of goods improves over time, but CPI does not account for improvements (smartphones with better features)
  • Prices adjusted to account for quality changes in goods and services
• New product bias
  • Occurs when new products introduced to market but not immediately included in CPI basket (streaming services)
  • Basket of goods and services regularly updated to include new products
• Outlet bias
  • Occurs when consumers shift purchases to lower-priced stores, but CPI does not account for change (shopping at discount stores)
  • Data collected from variety of outlets, including discount stores and online retailers

Other Price Indices

• Producer Price Index (PPI)
  • Measures average change in prices received by domestic producers for output
  • Focuses on goods and services sold by producers, rather than bought by consumers
  • Does not include imports or sales and excise taxes
• GDP deflator
  • Measures average change in prices of all goods and services included in Gross Domestic Product (GDP)
  • Calculated by dividing nominal GDP by real GDP and multiplying by 100
  • Formula: $GDP Deflator = \frac{Nominal GDP}{Real GDP} \times 100$
  • Includes all goods and services produced within country's borders, not just those in typical consumer's basket
  • Does not have fixed basket of goods and services, unlike CPI