Macroeconomics Dr/ Zeyad Albukhaiti

Lecture 4

Measuring the Cost of Living

Measuring The Price Level & Measuring Unemployment

1) Measuring The Price Level

There is a difference between price and the price level. The word price refers to a
single price, such the price of apples or the price of oranges. The price level is a
weighted average of all the prices of all the goods and services in the economy. The
key phrase in that definition is “a weighted average of all the prices.” Here is a rough
way of thinking about a price level: Suppose an economy consists of three goods:
apples, oranges, and pears. Suppose also that the prices of apples, oranges, and pears
are 50¢, 60¢, and 80¢ cents, respectively. Then the average price of these three
goods is 63¢. That is also the price level.
 Using the CPI to Compute the Price Level.
Economists measure the price level by constructing a price index. One major price
index is the Consumer Price Index (CPI). The CPI is based on a representative group
of goods and services, called the market basket, purchased by a typical household.
The market basket includes eight major categories of goods and services: (1) food and
beverages, (2) housing, (3) apparel, (4) transportation, (5) medical care, (6) recreation,
(7) education and communication, and (8) other goods and services.
To simplify our discussion, we assume that the market basket includes only three
goods instead of the many goods it actually contains. Our market basket consists of 10
pens, 5 shirts, and 3 pairs of shoes.
To calculate the CPI, first calculate the total dollar expenditure on the market
basket in two years: the current year and the base year. The base year is a benchmark
year that serves as a basis of comparison for prices in other years.
In Exhibit 1, we multiply the quantity of each good in the market basket (column 1)
by its current-year price (column 2) to compute the current-year expenditure on each
good (column 3).
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 4
By adding the dollar amounts in column 3, we obtain the total dollar expenditure on
the market basket in the current year. This amount is $167.
To find the total expenditure on the market basket in the base year, we multiply the
quantity of each good in the market basket (column 1A) by its base-year price
(column 2A) and then add all these products (column 3A). This gives us $67.
To find the CPI, we use the formula

𝑻𝒐𝒕𝒂𝒍 𝒅𝒐𝒍𝒍𝒂𝒓 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝒐𝒏 𝒎𝒂𝒓𝒌𝒆𝒕 𝒃𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓

CPI = × 100
𝑻𝒐𝒕𝒂𝒍 𝑻𝒐𝒕𝒂𝒍 𝒅𝒐𝒍𝒍𝒂𝒓 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝒐𝒏 𝒎𝒂𝒓𝒌𝒆𝒕 𝒃𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓

As shown in Exhibit 1, the current-year CPI for our tiny economy is 249.
Computing the Consumer Price Index
This exhibit uses hypothetical data to show how the CPI is computed. To find the
total dollar expenditure on market basket in current year, we multiply the quantities of
goods in the market basket by their current-year prices and add all the products.
This gives us $167. To find the total dollar expenditure on market basket in base
year, we multiply the quantities of goods in the market basket by their base-year
prices and add all the products. This gives us $67. We then divide $167 by $67 and
multiply the quotient by 100.
(1) (2) (3) (1A) (2A) (3A)
Market Current-Year Prices Current-Year Market Base-Year Prices Base-Year
Basket (Per Item) Expenditures Basket (Per Item) Expenditures
10 pens × $0.70 = $ 7.00 10 pens × $0.20 = $ 2.00
5 shirts × 14.00 = 70.00 5 shirts × 7.00 = 35.00
3 pairs of × 30.00 = 90.00 3 pairs of × 10.00 = 30.00
shoes shoes
$ 167.00 $ 67.00
Total dollar Total dollar
expenditure on expenditure on
market basket in market basket
current year in base year
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 4
𝑻𝒐𝒕𝒂𝒍 𝒅𝒐𝒍𝒍𝒂𝒓 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝒐𝒏 𝒎𝒂𝒓𝒌𝒆𝒕 𝒃𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓
CPI = × 100
𝑻𝒐𝒕𝒂𝒍 𝑻𝒐𝒕𝒂𝒍 𝒅𝒐𝒍𝒍𝒂𝒓 𝒆𝒙𝒑𝒆𝒏𝒅𝒊𝒕𝒖𝒓𝒆 𝒐𝒏 𝒎𝒂𝒓𝒌𝒆𝒕 𝒃𝒂𝒔𝒌𝒆𝒕 𝒊𝒏 𝒃𝒂𝒔𝒆 𝒚𝒆𝒂𝒓
$ 𝟏𝟔𝟕.𝟎𝟎
= × 100 = 249
$ 𝟔𝟕.𝟎𝟎

When We Know the CPI for Various Years, We Can Compute the Percentage
Change in Prices To find the percentage change in prices between any two years, use
the formula:

𝑪𝑷𝑰 𝒍𝒂𝒕𝒆𝒓 𝒚𝒆𝒂𝒓 − 𝑪𝑷𝑰 𝒆𝒂𝒓𝒍𝒍𝒚 𝒚𝒆𝒂𝒓

Percentage change in prices = × 100
𝑪𝑷𝑰 𝒆𝒂𝒓𝒍𝒍𝒚 𝒚𝒆𝒂𝒓

For example, if the CPI in 1990 was 130.7 and the CPI in 2005 was 195.3. The
percentage change in prices over this period was therefore 49.43 percent:

𝟏𝟗𝟓.𝟑 − 𝟏𝟑𝟎.𝟕
Percentage change = × 100 = 49.3
𝟏𝟑𝟎.𝟕
This means that prices increased 49.43 percent from 1990 to 2005. You can

think of the percentage change in prices in this way: What cost $1 in 1990 cost

approximately $1.49 in 2005.

 Inflation and the CPI

Inflation is an increase in the price level and is usually measured on an annual
basis. The inflation rate is the positive percentage change in the price level on an
annual basis. When you know the inflation rate, you can find out whether your
income is (1) keeping up with, (2) not keeping up with, or (3) more than keeping up
with inflation. How you are doing depends on whether your income is rising by (1)
the same percentage as, (2) a smaller percentage than, or (3) a greater percentage
than the inflation rate, respectively. When you make this computation and
comparison, you are determining your real income for different years.
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 4
Real income is a person’s nominal income (or current dollar amount of income)
adjusted for any change in prices. Real income is computed as follows:

𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝒊𝒏𝒄𝒐𝒎𝒆
Real Income = × 100
𝑪𝑷𝑰
Case 1. Keeping up with Inflation: Real Income Stays Constant Jim earns
$50,000 in year 1 and $55,000 in year 2. The CPI is 100 in year 1 and 110 in year 2,
so the inflation rate is 10 percent: [(110 2100) /100]3100 510. Jim’s income has
risen by 10 percent: [($55,000 2 $50,000) / $50,000]3100 510. Jim’s income has
risen by the same percentage as the inflation rate, so he has kept up with inflation.
This is evident when we see that Jim’s real income is the same in both years. In
year 1 it is $50,000, and in year 2 it is $50,000 too:

$𝟓𝟎,𝟎𝟎𝟎
Real Income year 1 = × 100 = $ 50,000
𝟏𝟎𝟎

$𝟓𝟓,𝟎𝟎𝟎
Real Income year 2 = × 100 = $ 50,000
𝟏𝟏𝟎
Case 2. Not Keeping up with Inflation: Real Income Falls Karen earns
$50,000 in year 1 and $52,000 in year 2. The CPI is 100 in year 1 and 110 in year 2.
Karen’s income has risen by 4 percent, and the inflation rate is 10 percent. Her
income has risen by a smaller percentage than the inflation rate, so she has not kept
up with inflation. Karen’s real income has fallen from $50,000 in year 1 to $47,273
in year 2:

$𝟓𝟎,𝟎𝟎𝟎
Real Income year 1 = × 100 = $ 50,000
𝟏𝟎𝟎

$𝟓𝟐,𝟎𝟎𝟎
Real Income year 2 = × 100 = $ 47,273
𝟏𝟏𝟎
Case 3. More than Keeping up with Inflation: Real Income Rises Carl earns
$50,000 in year 1 and $60,000 in year 2. The CPI is 100 in year 1 and 110 in year 2.
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 4
Carl’s income has risen by 20 percent, and the inflation rate is 10 percent. His
income has risen by a greater percentage than the inflation rate, so he has more than
kept up with inflation. Carl’s real income has risen from $50,000 in year 1 to
$54,545 in year 2:

$𝟓𝟎,𝟎𝟎𝟎
Real Income year 1 = × 100 = $ 50,000
𝟏𝟎𝟎

$𝟔𝟎,𝟎𝟎𝟎
Real Income year 2 = × 100 = $ 54,545
𝟏𝟏𝟎

2) Measuring Unemployment
 Reasons for Unemployment

Usually, we think of an unemployed person as someone who has been fired or laid
off from his or her job. Certainly, some unemployed persons fit this description, but
not all of them do. According to the BLS, an unemployed person may fall into one of
four categories:
1. Job loser. This person was employed in the civilian labor force and was either
fired or laid off. Most unemployed persons fall into this category.
2. Job leaver. This person was employed in the civilian labor force and quit the job.
For example, if Jim quit his job with company X and is looking for a better job,
he is a job leaver.
3. Reentrant. This person was previously employed, hasn’t worked for some time,
and is currently reentering the labor force.
4. New entrant. This person has never held a full-time job for two weeks or longer
and is now in the civilian labor force looking for a job.
In sum,
Unemployed persons = Job losers + Job leavers + Reentrants + New entrants
 Macroeconomics Dr/ Zeyad Albukhaiti
Lecture 4

 Types of Unemployment

There are several different types of unemployment:

1- Frictional Unemployment

Frictional Unemployment. Unemployment that is due to the natural so-called

frictions in the economy and that is caused by changing market conditions and
represented by qualified individuals with transferable skills who change jobs.
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒓𝒊𝒄𝒕𝒊𝒐𝒏𝒂𝒍𝒍𝒚 𝒖𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒑𝒆𝒓𝒔𝒐𝒏𝒔
UF = 𝑪𝒊𝒗𝒊𝒍𝒊𝒂𝒏 𝒍𝒂𝒃𝒐𝒓 𝒇𝒐𝒓𝒄𝒆
× 100

2- Structural Unemployment

Structural Unemployment. Unemployment due to structural changes in the economy

that eliminate some jobs and create others for which the unemployed are unqualified.
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒔𝒕𝒓𝒖𝒄𝒕𝒖𝒓𝒂𝒍𝒍𝒚 𝒖𝒏𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒑𝒆𝒓𝒔𝒐𝒏𝒔
US = 𝑪𝒊𝒗𝒊𝒍𝒊𝒂𝒏 𝒍𝒂𝒃𝒐𝒓 𝒇𝒐𝒓𝒄𝒆
× 100

3- Natural Unemployment

Natural Unemployment. Unemployment caused by frictional and structural

factors in the economy:

UN rate = Frictional unemployment rate + Structural unemployment rate