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CheckPoint: Calculation of the Consumer Price Index (CPI) The

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CheckPoint: Calculation of the Consumer Price Index (CPI)
The Bureau of Labor Statistics follows five steps to calculate Consumer Price Index.
? Resource: Ch. 24 (pp. 520-522) of Principles of Economics and Appendix D
? Due Date: Day 5 [Individual] forum
? Review Appendix D. Using the chart provided, identify three strengths and three weaknesses of the calculation.
? Post a 200- to 300-word response that answers the following questions once your chart is complete:
o What are the characteristics of the items listed as strengths?
o What are the characteristics of the items listed as weaknesses?
o If the CPI is imperfect, why do we use it?
THE 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. Each month the Bureau of Labor Statistics,
which is part of the Department of Labor, computes and reports the consumer
price index. In this section we discuss how the consumer price index is calculated
and what problems arise in its measurement. We also consider how this index
compares to the GDP deflator, another measure of the overall level of prices, which
we examined in the preceding chapter.
How the Consumer Price Index Is Calculated
When the Bureau of Labor Statistics calculates the consumer price index and the
inflation rate, it uses data on the prices of thousands of goods and services. To see
exactly how these statistics are constructed, let’s consider a simple economy in
which consumers buy only two goods—hot dogs and hamburgers. Table 1 shows
the five steps that the Bureau of Labor Statistics follows.
1. Fix the basket. The first step in computing the consumer price index is to determine
which prices are most important to the typical consumer. If the typical
consumer buys more hot dogs than hamburgers, then the price of hot dogs is
more important than the price of hamburgers and, therefore, should be given
greater weight in measuring the cost of living. The Bureau of Labor Statistics
sets these weights by surveying consumers and finding the basket of goods and
services that the typical consumer buys. In the example in the table, the typical
consumer buys a basket of 4 hot dogs and 2 hamburgers.
2. Find the prices. The second step in computing the consumer price index is to find
the prices of each of the goods and services in the basket for each point in time.
The table shows the prices of hot dogs and hamburgers for three different years.
3. Compute the basket’s cost. The third step is to use the data on prices to calculate
the cost of the basket of goods and services at different times. The table shows
this calculation for each of the three years. Notice that only the prices in this calculation
change. By keeping the basket of goods the same (4 hot dogs and 2
520 PART 8 THE DATA OF MACROECONOMICS
consumer price index (CPI)
a measure of the overall cost of
the goods and services bought
by a typical consumer
Principles of Economics, 3e, Mankiw - © 2004 N. Gregory Mankiw
hamburgers), we are isolating the effects of price changes from the effect of any
quantity changes that might be occurring at the same time.
4. Choose a base year and compute the index. The fourth step is to designate one year
as the base year, which is the benchmark against which other years are compared.
To calculate the index, the price of the basket of goods and services in
each year is divided by the price of the basket in the base year, and this ratio is
then multiplied by 100. The resulting number is the consumer price index.
In the example in the table, the year 2001 is the base year. In this year, the basket
of hot dogs and hamburgers costs $8. Therefore, the price of the basket in
all years is divided by $8 and multiplied by 100. The consumer price index is
100 in 2001. (The index is always 100 in the base year.) The consumer price index
is 175 in 2002. This means that the price of the basket in 2002 is 175 percent
of its price in the base year. Put differently, a basket of goods that costs $100 in
the base year costs $175 in 2002. Similarly, the consumer price index is 250 in
2003, indicating that the price level in 2003 is 250 percent of the price level in the
base year.
CHAPTER 24 MEASURING THE COST OF LIVING 521
Calculating the
Consumer Price Index
and the Inflation Rate:
An Example
This table shows how to calculate
the consumer price index and the
inflation rate for a hypothetical
economy in which consumers buy
only hot dogs and hamburgers.
TABLE 1
Step 1: Survey Consumers to Determine a Fixed Basket of Goods
4 hot dogs, 2 hamburgers
Step 2: Find the Price of Each Good in Each Year
Year Price of Hot Dogs Price of Hamburgers
2001 $1 $2
2002 2 3
2003 3 4
Step 3: Compute the Cost of the Basket of Goods in Each Year
2001 ($1 per hot dog  4 hot dogs)  ($2 per hamburger  2 hamburgers)  $8
2002 ($2 per hot dog  4 hot dogs)  ($3 per hamburger  2 hamburgers)  $14
2003 ($3 per hot dog  4 hot dogs)  ($4 per hamburger  2 hamburgers)  $20
Step 4: Choose One Year as a Base Year (2001) and Compute the Consumer Price Index
in Each Year
2001 ($8/$8)  100  100
2002 ($14/$8)  100  175
2003 ($20/$8)  100  250
Step 5: Use the Consumer Price Index to Compute the Inflation Rate from Previous Year
2002 (175  100)/100  100  75%
2003 (250  175)/175  100  43%
Principles of Economics, 3e, Mankiw - © 2004 N. Gregory Mankiw
5. Compute the inflation rate. The fifth and final step is to use the consumer price index
to calculate the inflation rate, which is the percentage change in the price
index from the preceding period. That is, the inflation rate between two consecutive
years is computed as follows:
Inflation rate in year 2  100.
In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003.
Although this example simplifies the real world by including only two goods, it
shows how the Bureau of Labor Statistics (BLS) computes the consumer price index
and the inflation rate. The BLS collects and processes data on the prices of
thousands of goods and services every month and, by following the five foregoing
steps, determines how quickly the cost of living for the typical consumer is rising.
When the BLS makes its monthly announcement of the consumer price index, you
CPI in year 2  CPI in year 1
CPI in year 1
522 PART 8 THE DATA OF MACROECONOMICS
When constructing the consumer price index, the Bureau of Labor
Statistics tries to include all the goods and services that the typical
consumer buys. Moreover, it tries to weight these goods and services
according to how much consumers buy of each item.
Figure 1 shows the breakdown of consumer spending into the major
categories of goods and services. By far the largest category is
housing, which makes up 41 percent of the typical consumer’s budget.
This category includes the cost of shelter (31 percent), fuel and
other utilities (5 percent), and household furnishings and operation (5
percent). The next largest category, at 17 percent, is transportation,
which includes spending on cars, gasoline, buses, subways, and so on.
The next category, at 16 percent, is food and beverages; this includes
food at home (9 percent), food away from home (6 percent), and alcoholic
beverages (1 percent). Next are medical care, recreation, and
education and communication, each at about 6 percent. This last category
includes, for example, college tuition and personal computers.
Apparel, which includes clothing, footwear, and jewelry, makes up 4
percent of the typical consumer’s budget.
Also included in the figure, at 4 percent of spending, is a category
for other goods and services. This is a catchall for things consumers
WHAT IS IN THE CPI’S BASKET?
buy that do not naturally fit into the other categories—such as cigarettes,
haircuts, and funeral expenses.
16%
Food and
beverages
17%
Transportation
Other goods
and services
Medical care
Recreation Apparel
6%
6% 4% 4%
6%
41%
Housing
Education and
communication
FIGURE 1
The Typical Basket of Goods and Services
This figure shows how the typical consumer divides his
spending among various categories of goods and services.
The Bureau of Labor Statistics calls each percentage the
“relative importance” of the category.
Source: Bureau of Labor Statistics.
inflation rate
the percentage change in the price
index from the preceding period
Principles of Economics, 3e, Mankiw - © 2004 N. Gregory Mankiw
can usually hear the number on the evening television news or see it in the next
day’s newspaper.
In addition to the consumer price index for the overall economy, the Bureau of
Labor Statistics calculates several other price indexes. It reports the index for specific
regions within the country (such as Boston, New York, and Los Angeles) and
for some narrow categories of goods and services (such as food, clothing, and energy).
It also calculates the producer price index, which measures the cost of a basket
of goods and services bought by firms rather than consumers. Because firms
eventually pass on their costs to consumers in the form of higher consumer prices,
changes in the producer price index are often thought to be useful in predicting
changes in the consumer price index.
Problems in Measuring the Cost of Living
The goal of the consumer price index is to measure changes in the cost of living. In
other words, the consumer price index tries to gauge how much incomes must rise
in order to maintain a constant standard of living. The consumer price index, however,
is not a perfect measure of the cost of living. Three problems with the index
are widely acknowledged but difficult to solve.
The first problem is called substitution bias. When prices change from one year
to the next, they do not all change proportionately: Some prices rise more than others.
Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by large amounts and by buying more of the goods
whose prices have risen less or perhaps even have fallen. That is, consumers substitute
toward goods that have become relatively less expensive. If a price index is
computed assuming a fixed basket of goods, it ignores the possibility of consumer
substitution and, therefore, overstates the increase in the cost of living from one
year to the next.
Let’s consider a simple example. Imagine that in the base year, apples are
cheaper than pears, and so consumers buy more apples than pears. When the Bureau
of Labor Statistics constructs the basket of goods, it will include more apples
than pears. Suppose that next year pears are cheaper than apples. Consumers will
naturally respond to the price changes by buying more pears and fewer apples.
Yet, when computing the consumer price index, the Bureau of Labor Statistics uses
a fixed basket, which in essence assumes that consumers continue buying the now
expensive apples in the same quantities as before. For this reason, the index will
measure a much larger increase in the cost of living than consumers actually experience.
The second problem with the consumer price index is the introduction of new
goods. When a new good is introduced, consumers have more variety from which
to choose. Greater variety, in turn, makes each dollar more valuable, so consumers
need fewer dollars to maintain any given standard of living. Yet because the consumer
price index is based on a fixed basket of goods and services, it does not reflect
this change in the purchasing power of the dollar.
Again, let’s consider an example. When VCRs were introduced, consumers
were able to watch their favorite movies at home. Compared with going to a movie
theater, the convenience was greater and the cost was less. A perfect cost-of-living
index would have reflected the introduction of the VCR with a decrease in the cost
of living. The consumer price index, however, did not decrease in response to the
introduction of the VCR. Eventually, the Bureau of Labor Statistics did revise the
CHAPTER 24 MEASURING THE COST OF LIVING 523
producer price index
a measure of the cost of a basket of
goods and services bought by firms
Principles of
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