Measuring the Cost of Living

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  • Topic: Inflation, Price index, Consumer price index
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Chapter 24
Measuring the Cost of Living

Introduction

1931 – Year of Great Depression in the USA. But in spite of this fact some people contrived to earn $80 000, it was famous baseball player Babe Ruth. Even the President Herberd Hoover had a lesser salary of $75 000. When Ruth was asked if he thought it was right that his salary was higher than President’s he replied that he had a better year. Year of 2007 describes a different picture. The average baseball player gets paid $4.8 million. We consider the fact that the cost of living, products and services has grown in recent decades. But it does not give us any explanation if Babe Ruth had a better standard of living than the average baseball player now, because prices for goods and services were significantly lower than nowadays. The quantity of produced goods and services within the state shows the GDP. But how to measure the total cost of living? To answer this question we need to find out how to turn dollar into consumer price index (a relevant unit which measures the overall cost of goods and services purchased by a customer) to be able to compare cost of living over the time. Inflation – situation when total cost of goods and services increases. In this way expenditures of the average family increase in order to maintain the same standard of living. Inflation rate – changes in price level from the earlier terms in percentages. The better way to measure the inflation rate is to use the CPI (consumer price index) with statistics. The former shows the cost of living over the time.

The Consumer Price Index (CPI)

The CPI and inflation rate are calculated by the Bureau of Labor Statistics by computing prices of hundreds of goods and services. For better understanding and explanation pretend that consumers buy only two products pizza and coke

How to calculate the CPI?

1.Fix the basket. Measuring the cost of living we should identify which product is more important to the consumer. If the customer buys more coffee, then the price of coffee is more important, consequently it gives more value to measure the cost of living. 2.Fix the price. To set the price for each product or service for a period of time. 3.Calculate the basket’s cost. To sum up all products and services in basket at given periods of time. 4.Choose the base year and find the index. Choosing the base year is elective. The formula to calculate the

CPI= Price of basket of goods and services in current year
Price of basket in base year X 100 5.Calculate the inflation rate.
Inflation rate = CPI in year 2 – CPI in year 1 X100
CPI in year 1

There are only two products in this example, what makes it easier to understand. But Bureau of Labor Statistics deals with hundreds of goods and services every month to calculate the CPI and inflation rate. This example shows the speed of growing cost of living for a typical customer. Besides the CPI, Bureau also calculates PPI (producer price index). It shows the cost of basket of producer.

1.Fix the basket
4 Pizzas, 6 Cokes
2. Find the prices
YearPrice of Pizza Price of Coke
2008 $5 $1
2009 $10 $2
2010 $15 $3

3. Compute the basket’s cost

2008 ($5 per pizza X 4 pizzas)+($1 per coke X 6 cokes) = $26 2009 ($10 per pizza X 4 pizzas)+($2 per coke X 6 cokes) = $52 2010 ($15 per pizza X 4 pizzas)+($3 per coke X 6 cokes) = $78

4. Choose a base year and compute the index

2008($26/$26)X100=100
2009($52/$26)X100=200
2010($78/$26)X100=300

5. Compute the inflation rate

2009 (200-100)/100 X100= 0.001%
2010 (300-200)/200 X100= 0.005%

Problems in Measuring the Cost of Living

There are three problems which may occur in measuring the Cost of Living.

Substitution bias – prices of some goods rise in different proportions, some...
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