LECTURE  NOTES  ON  
MACROECONOMIC  PRINCIPLES  
 
Peter  Ireland  
Department  of  Economics  
Boston  College  
 
[email protected]
http://www2.bc.edu/peter-ireland/ec132.html  

Copyright  (c)  2013  by  Peter  Ireland.  Redistribution  is  permitted  for  educational  and  research  purposes,  
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Ch  24  Measuring  the  Cost  of  Living  
Introduction  
In  1931,  the  New  York  Yankees  paid  Babe  Ruth  an  annual  salary  of  $80,000.  

In  2010,  the  New  York  Yankees  paid  Alex  Rodriguez  an  annual  salary  of  $33  million.  

But  then  again,  in  1931  an  ice  cream  cone  cost  a  nickel  and  a  movie  ticket  cost  a  quarter.    More  
generally,  the  cost  of  living  has  risen  greatly  since  then.  

This  chapter  focuses  on  the  consumer  price  index  or  the  CPI  as  a  measure  of  the  cost  of  living.  

The  inflation  rate  is  the  percentage  rate  of  change  in  the  CPI.  

Once  we  understand  how  the  CPI  is  constructed  and  how  it  has  behaved  in  the  US,  we  can  return  to  the  
question:  who  was  really  paid  more,  after  adjusting  for  inflation,  Ruth  or  Rodriguez?  

Outline  
1. The  Consumer  Price  Index  
A. How  the  CPI  is  Measured  
B. Problems  in  Measuring  the  Cost  of  Living  
C. The  GDP  Deflator  and  the  CPI  
2. Correcting  Economic  Variables  for  the  Effects  of  Inflation  
A. Dollar  Figures  at  Different  Points  in  Time  
B. Indexation  
C. Real  and  Nominal  Interest  Rates  

The  Consumer  Price  Index  

The  CPI  is  computed  by  the  Bureau  of  Labor  Statistics  (BLS),  a  division  of  the  Department  of  Labor,  to  
measure  the  overall  cost  of  goods  and  services  bought  by  a  typical  consumer.  

How  the  CPI  is  Measured  

Table  1  highlights  the  5  steps  involved  in  measuring  the  CPI:  

1. Survey  consumers  to  determine  the  relevant  “basket  of  goods.”    

2. Record  the  price  of  each  good  in  each  year.  
3. Compute  the  cost  of  the  basket  in  each  year.  
4. Choose  a  base  year  and  compute  the  CPI  for  the  current  year:  
Cost of the Basket in the Current Year
CPI = × 100  
Cost of the Basket in a Base Year
 2  
 

5. Compute  the  inflation  rate  as  the  percentage  change  in  the  CPI  from  one  year  to  the  next:  
CPI in Current Year − CPI in Previous Year
Inflation Rate = × 100  
CPI in Previous Year

The  example  in  Table  1  assumes,  for  simplicity,  that  the  basket  includes  only  two  goods.  Figure  1  
illustrates  in  more  detail  what  is  really  in  the  CPI  basket.  

In  addition  to  the  CPI,  the  BLS  also  computes  the  producer  price  index  or  the  PPI,  to  measure  the  cost  of  
goods  and  services  bought  by  the  typical  firm.  

Problems  in  Measuring  the  Cost  of  Living  

Three  problems  prevent  the  CPI  from  being  a  perfect  measure  of  the  cost  of  living:  

1. Substitution  bias.  
2. The  introduction  of  new  goods.  
3. Unmeasured  quality  change.  

Substitution  bias  arises  because  in  any  given  year  the  prices  of  some  goods  rise  faster  than  others:  

-­‐ The  basket  holds  the  quantity  of  each  good  purchased  fixed.  
-­‐ But,  in  fact,  consumers  tend  to  substitute  less  expensive  goods  for  more  expensive  goods.  

Does  substitution  bias  cause  the  CPI  to  overstate  or  understand  the  true  change  in  the  cost  of  living?  

To  answer  this  question,  return  to  the  example  from  Table  1:  

-­‐ There,  the  price  of  hot  dogs  rises  at  a  faster  rate  than  the  price  of  hamburgers.  
-­‐ The  CPI  holds  the  number  of  hot  dogs  and  the  number  of  hamburgers  fixed.  
-­‐ But,  in  reality,  consumers  are  likely  to  buy  more  hamburgers  and  fewer  hot  dogs.  
-­‐ Hence  the  true,  changing  basket  of  goods  is  less  expensive  than  the  fixed  basket  used  in  
computing  the  CPI.  
-­‐ The  CPI  therefore  overstates  the  true  change  in  the  cost  of  living.  

When  new  goods  are  introduced,  the  true  cost  of  achieving  a  given  level  of  consumer  satisfaction  falls.    

-­‐ Before  VCRs  and  DVD  players  were  invented,  if  you  wanted  to  see  a  movie,  you  had  to  either  go  
to  a  theater  or  wait  for  it  to  come  on  TV.  
-­‐ Even  after  those  new  goods  were  introduced,  you  could  still  go  to  the  theater  or  watch  movies  
on  TV,  but  you  could  also  rent  or  buy  the  video.  
-­‐ So  a  given  number  of  dollars  spent  watching  movies  could  yield  a  higher  level  of  consumer  
satisfaction.  
-­‐ In  that  sense,  the  cost  of  living  goes  down  when  new  goods  are  introduced,  but  that  effect  does  
not  get  captured  by  the  CPI.    
-­‐ So  it  again  the  CPI  overtstates  the  true  change  in  the  cost  of  living.  

Unmeasured  quality  change:  many  types  of  goods  improve  in  quality  over  time.  
 3  
 

-­‐ A  new  cellphone  purchased  today  is  a  lot  better  than  a  cellphone  purchased  two  or  three  years  
ago,  even  if  it  sells  at  a  higher  price.  
-­‐ The  BLS  tries  to  correct  for  this  quality  change.  
-­‐ But  to  the  extent  that  it  underestimates  the  extent  of  quality  change,  it  again  overstates  the  
true  change  in  the  cost  of  living.  

Many  economists  believe  that  the  because  of  the  combined  effects  of  these  three  problems,  the  
inflation  rate  based  on  the  CPI  overstates  the  true  increase  in  the  cost  of  living  by  about  0.5  percentage  
points  per  year.  These  effects  are  important,  since  for  example,  Social  Security  benefits  get  adjusted  
upwards  automatically  in  a  way  that  is  tied  to  the  CPI  inflation  rate.  

The  GDP  Deflator  and  the  CPI  

Usually,  the  GDP  deflator  and  the  CPI  move  together,  as  shown  in  Figure  2.  

One  difference,  however,  arises  because:  

-­‐ The  GDP  deflator  reflects  the  prices  of  all  goods  produced  domestically.  
-­‐ Whereas  the  CPI  reflects  the  prices  of  all  goods  consumed  domestically.  

So  let’s  ask:  what  happens  when  the  price  of  an  imported  good  rises?  

-­‐ The  CPI  increases.  

-­‐ But  the  GDP  deflator  does  not.  
-­‐ This  effect  is  particularly  important  when  the  price  of  imported  oil  rises.  

What  happens  when  the  price  of  a  domestically-­‐produced  capital  (investment)  good  rises?  

-­‐ The  GDP  deflator  increases.  

-­‐ But  the  CPI  does  not.  

A  second  and  more  subtle  difference  arises  because:  

-­‐ The  GDP  deflator  is  based  on  the  prices  of  goods  as  currently  produced.  
-­‐ Whereas  the  CPI  is  based  on  the  prices  of  a  fixed  basket  of  goods.  
-­‐ So  differences  arise  when  the  prices  of  different  goods  are  rising  or  falling  at  different  rates.  

Correcting  Economic  Variables  for  the  Effects  of  Inflation  

Dollar  Figures  at  Different  Points  in  Time  

Let’s  go  back  to  the  question  from  the  beginning:  after  correcting  for  inflation,  who  was  paid  more,  Ruth  
($80,000)  in  1931  or  Rodriguez  ($33  million)  in  2010?  

To  answer  this  question,  ask  first:  how  many  “baskets”  of  goods  could  Ruth  buy  in  1931?  
 4  
 

$80,000 in 1931
Number of Baskets Bought by Ruth in 1931 =  
Cost of Each Basket in 1931

Now  ask,  how  much  would  this  same  number  of  baskets  have  cost  in  2010?  

2010 Cost of the Baskets Bought by Ruth in 1931

= Cost of Each Basket in 2010 × Number of Baskets Bought by Ruth in 1931  
$80,000 in 1931
= Cost of Each Basket in 2010 ×
Cost of Each Basket in 1931

This  last  formula  can  be  rewritten  as:  

2010 Cost of the Baskets Bought by Ruth in 1931

Cost of Each Basket in 2010
= × 100  
Cost of Each Basket in a Base Year
Cost of Each Basket in a Base Year 1
× × × $80,000 in 1931
Cost of Each Basket in 1931 100

But  now  it  simplifies  to:  

CPI in 2010
2010 Cost of the Baskets Bought by Ruth in 1931 = × $80,000 in 1931  
CPI in 1931

This  equation  is  true  more  generally:  

CPI This Year

Value in this Year's Dollars = Value in a Past Year's Dollars ×  
CPI in the Past Year

It  turns  out  that  

CPI  in  1931  =  15.2  

CPI  in  2010  =  218  (note:  Mankiw  uses  the  CPI  for  2009,  which  was  214.5).  

And  so,  doing  the  math:  

218
Value of Ruth' s Salary in 2010 Dollars = $80,000 in 1931 Dollars × = $1,147,368  
15.2

Even  after  adjusting  for  inflation,  Rodriguez’s  salary  is  much,  much  higher!  

But,  interestingly,  President  Herbert  Hoover’s  1931  salary  was  $75,000.  Let’s  convert  that  into  2010  
dollars  in  the  same  way:  

218
Value of Hoover' s Salary in 2010 Dollars = $75,000 in 1931 Dollars × = $1,075,658
15.2  
 5  
 

 
After  adjusting  for  inflation,  Hoover’s  salary  is  more  than  twice  as  large  as  the  $400,000  earned  in  2010  
by  President  Barack  Obama.  

Indexation  
Indexation  refers  to  the  automatic  correction  by  law  or  contract  of  a  dollar  amount  for  the  effects  of  
inflation.  

As  noted  above,  Social  Security  benefits  are  indexed,  that  is,  adjusted  every  year  based  on  the  
percentage  increase  in  the  CPI.  

Union  contracts  often  specify  indexed  wages  that  increase  each  year  based  on  the  inflation  rate.  Such  a  
provision  is  often  referred  to  as  a  cost-­‐of-­‐living  allowance  (COLA).  

Real  and  Nominal  Interest  Rates  

Since  bank  accounts,  bonds,  automobile  loans,  and  mortgages  all  make  or  require  dollar  payments  at  
different  points  in  time,  the  interest  rates  on  these  investments  or  loans  must  also  be  corrected  for  the  
effects  of  inflation  to  gauge  their  true  economic  significance.  

Suppose,  for  example,  that  you  deposit  $1,000  in  a  bank  account  that  pays  interest  at  a  10%  annual  rate:  

-­‐ One  year  from  now,  you  will  have  $1,100:  your  original  $1,000  plus  $100  interest.  
-­‐ But  let’s  say  that  the  inflation  rate  over  the  next  year  is  3%.  
-­‐ You  have  10%  more  dollars,  but  those  dollars  buy  3%  less.  
-­‐ Your  “real”  return  is  actually  10%  -­‐  3%  =7%.  

In  this  example,  the  nominal  interest  rate,  that  is,  the  interest  rate  as  it  is  usually  reported  without  
correcting  for  inflation,  is  10%.  

But  the  real  interest  rate,  corrected  for  the  effects  of  inflation,  is  7%.  

In  general:  

Real Interest Rate = Nominal Interest Rate − Inflation Rate  

Note  that  the  real  interest  rate  can  even  be  negative:  if  the  nominal  interest  rate  on  your  bank  account  
is  10%,  but  the  inflation  rate  turns  about  to  be  12%,  the  real  interest  rate  is  10%-­‐12%=-­‐2%.  

Most  frequently,  prices  rise  over  time,  so  that  the  inflation  rate  is  positive.  But  sometimes,  as  in  the  US  
economy  during  the  Great  Depression  of  the  1930s  and  in  Japan  during  the  last  decade,  prices  actually  
fall  over  time,  so  that  the  inflation  rate  is  negative.  These  are  periods  of  deflation  as  opposed  to  
inflation.  

Which  is  bigger:  the  nominal  interest  rate  or  the  real  interest  rate?  
 6  
 

-­‐ Under  inflation,  the  nominal  interest  rate  is  bigger  than  the  real  interest  rate  s ince  the  value  of  
dollars  is  falling  over  time.  
-­‐ Under  deflation,  the  real  interest  rate  is  bigger  than  the  nominal  interest  rate  since  the  value  of  
dollars  is  rising  over  time.  

Figure  3  shows  the  relationship  between  nominal  and  real  interest  rates  in  the  US:  

-­‐ During  the  1970s,  nominal  interest  rates  were  high  but  real  interest  rates  were  low.  Why?  
Because  inflation  was  high.  
-­‐ During  the  1980s  and  1990s,  nominal  interest  rates  were  low  but  real  interest  rates  were  high.  
Why?  Because  inflation  was  low.  

This  is  an  important  lesson  for  personal  finance  and  investing:  when  evaluating  the  payoff  on  an  
investment  or  the  interest  rate  on  a  loan,  you  need  to  make  a  judgment  on  what  the  inflation  rate  will  
be  over  the  lifetime  of  the  investment  or  loan,  to  convert  the  nominal  interest  rate  into  a  real  interest  
rate.