The CPI and the

Cost of Living

CHAPTER

22

22.1 THE CONSUMER PRICE INDEX

Consumer Price Index (CPI) is a measure of the
average of the prices paid by consumers for a fixed
market basket of consumer goods and services.
The Malaysias Department of Statistics calculates the
CPI every month.
We can use these numbers to compare what a fixed
basket of goods costs this month with what it cost in
some previous month.

22.1 THE CONSUMER PRICE INDEX

Reading the CPI Numbers

The CPI is defined to equal 100 for a period called the
reference base period.

Reference base period is a period for which the CPI

is defined to equal 100. Currently, the reference base
period in Malaysia is 2005.

22.1 THE CONSUMER PRICE INDEX

In 2006, the CPI in Malaysia was 103.6.

The average of the prices paid by consumers for a

fixed market basket of consumer goods and
services was 3.6 percent higher in 2006 than it was
in the base year 2005.

22.1 THE CONSUMER PRICE INDEX

Constructing the CPI

Three stages:
Selecting the CPI basket
Conducting the monthly price survey
Calculating the CPI

22.1 THE CONSUMER PRICE INDEX

The CPI Basket

Make the relative importance of the items in the CPI
basket the same as in the budget of an average
household.
The CPI is calculated each month, but the CPI basket is
not updated each month.
The current CPI basket in Malaysia in 2007 is based on
information obtained from the Household Expenditure
Survey conducted during 2004/2005.

22.1 THE CONSUMER PRICE INDEX

The CPI Basket in Malaysia and its weights
CPI Basket

Weights

Food & non-alcoholic beverages

31.4%

Housing, water, electricity, gas & other fuel

21.4%

Transport

15.9%

Communication

5.1%

Recreation

4.6%

Furnishing & household equipment & maintenance

4.3%

Clothing & footwear

3.1%

Restaurants & hotels

3.0%

Education

1.9%

Alcoholic beverages & tobacco

1.9%

Health

1.4%

22.1 THE CONSUMER PRICE INDEX

Figure 22.1 shows the CPI basket in US.
This shopping cart is filled with the items that an average
household buys.

22.1 THE CONSUMER PRICE INDEX

Calculating the CPI
The CPI calculation has three steps:
Find the cost of the CPI basket at base period
prices.
Find the cost of the CPI basket at current period
prices.
Calculate the CPI for the base period and the
current period.
Table 22.1 on the next slide shows a simplified CPI
calculation in which we assume a base period of 2005.

22.1 THE CONSUMER PRICE INDEX

22.1 THE CONSUMER PRICE INDEX

CPI =

Cost of CPI basket at current period prices x 100

Cost of CPI basket at base period prices

For 2005, the CPI is:

$50
$50

x 100 = 100

For 2008, the CPI is:

$70
$50

x 100 = 140

22.1 THE CONSUMER PRICE INDEX

Measuring Inflation
Inflation rate is the percentage change in the price
level from one year to the next.

Inflation rate =

CPI in current year CPI in previous yearx 100

CPI in previous year

Inflation rate =

140 120 x 100 = 16.7 percent

120

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Cost of living index is a measure of changes in the
amount of money that people would need to spend to
achieve a given standard of living.
The CPI is not a perfect measure of the cost of living
because:
It does not measure all the components of the cost
of living
Some components are not measured exactly
So the CPI is possibly a biased measure.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Sources of Bias in the CPI

The potential sources of bias in the CPI are

New goods bias

Quality change bias
Commodity substitution bias
Outlet substitution bias

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

New Goods Bias
New goods (computer) do a better job than the old
goods (typewritter) that they replace, but cost more
The arrival of new goods puts an upward bias into
the CPI and its measure of the inflation rate.
Quality Change Bias
Better cars and televisions cost more than the
versions they replace.
A price rise that is a payment for improved quality
is not inflation but might get measured as inflation.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Commodity Substitution Bias
If the price of beef rises faster than the price of
chicken, people buy more chicken and less beef.
The CPI basket doesnt change to allow for the
effects of substitution between goods.
Outlet Substitution Bias
If prices rise more rapidly, people use discount
stores more frequently.
The CPI basket doesnt change to allow for the
effects of outlet substitution.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

The Magnitude of the Bias
In US, the Boskin Commission estimated the bias to be
1.1 percentage points per year.
If the measured inflation rate is 3.1 percent a year, most
likely the actual inflation rate is 2.0 percent a year.

To reduce the bias, the US Bureau of Labor Statistics

(BLS) has decided to increase the frequency of its
Consumer Expenditure Survey and revise the CPI
basket every two years.
When the BLS revises the CPI basket, the reference
base period does not change.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Two Consequences of the CPI Bias

Two main consequences of the bias in the CPI are
Distortion of private contracts
Increases in government outlays and decreases in
taxes
Distortion of Private Contracts
Many wage contracts are linked to the CPI.
If the CPI is biased, these contracts might deliver an
outcome different from that intended by the parties.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Suppose that the UAW (United Auto Workers Union) and GM
(General Motors Corp.) sign a 3 year wage deal: In the first
year, the wage will be $30 an hour and will rise by the
inflation rate in the next two years.
If the inflation rate is 5 percent a year, the wage rises to
$31.50 an hour in the second year and $33.08 an hour in the
third year.
But if the actual inflation rate is 2 percent a year, the intended
wages in the second and third years are $30.90 an hour and
$31.83 an hour.

The workers gain is GMs loss. With thousands of workers,

GMs loss would be millions of dollars over the 3 years.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Increases in Government Outlays and Decreases in
Taxes
Close to a third of federal government outlays are linked
directly to the CPI.
The CPI is used to adjust
48 million Social Security benefit payments
22 million food stamp payments
4 million pensions for retired military personnel,
federal civil servants, and their surviving spouses
the budget for 27 million school lunches

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

The CPI is used to adjust the income levels at which
higher tax rates apply.
Because tax rates on large incomes are higher than
those on small incomes as incomes rise, the burden of
taxes would rise relentlessly if these adjustments were
not made.
To the extent that the CPI is biased upward, the tax
adjustments over-compensate for rising prices and
decrease the amount paid in taxes.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Alternative Measures of the Price Level

Several alternative measures of the price level are
available.
Here we look at
The GDP deflator
The personal consumption expenditures deflator
(PCE deflator)

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

GDP Deflator

The GDP deflator is an average of current prices of all

the goods and services included in GDP expressed as a
percentage of base-year prices.
GDP deflator = (Nominal GDP Real GDP) 100.
The GDP deflator is a measure of the price level and
the percentage change in the GDP deflator is a
measure of the inflation rate.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Two key differences between the GDP deflator and the CPI
result in different estimates of the price level and inflation
rate.
1.The GDP deflator uses the prices of all the goods and
services in GDP whereas the CPI uses prices of
consumption goods and services in CPI basket.
2. The GDP deflator weights each item using
information about current as well as past quantities.
In contrast, the CPI weights each item using
information from a past consumer expenditure survey.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Because the GDP deflator uses information on current
year quantities, it includes new goods and quality
improvements and even allows for substitution effects of
both commodities and retail outlets.

So in principle, the GDP deflator is not subject to the

biases of the CPI.

22.2 THE CPI AND OTHER PRICE LEVEL MEASURES

Personal Consumption Expenditures (PCE) Deflator
The PCE deflator is an average of current prices of all
the goods and services included in the consumption
expenditure component of GDP expressed as a
percentage of base-year prices.
PCE deflator = (Nominal consumption expenditure in
GDP Real consumption expenditure in
GDP) 100.
The PCE deflator has the same advantages as GDP
deflatorit uses current information on quantities and to
some degree overcomes the sources of bias in the CPI.

22.3 NOMINAL AND REAL VALUES

Ringgit and Cents at Different Dates

To compare ringgit amounts at different dates, we need
to know the CPI at those dates.
Convert the price of a 2-cent stamp in 1907 into its 2007
equivalent:

Price of stamp in 2007 ringgit =

CPI in 2007
Price of stamp in 1907 ringgit x
CPI in 1907
207.2
= 41 cents
= 2 cents x
10.0

22.3 NOMINAL AND REAL VALUES

Ringgit and Cents at Different Dates

To compare ringgit amounts at different dates, we need
to know the CPI at those dates.
Convert the price of a 41 cent stamp in 2007 into its
1907 equivalent:
Price of stamp in 1907 ringgit =
Price of stamp in 2007 ringgit x CPI in 1907
CPI in 2007
10.0
= 2 cents
= 41 cents x
207.2

22.3 NOMINAL AND REAL VALUES

Nominal and Real Values in Macroeconomics

Macroeconomics makes a big issue of the distinction
between nominal values and real values:
Nominal GDP and real GDP
Nominal wage rate and real wage rate
Nominal interest rate and real interest rate
We studied the distinction between and calculation of
nominal and real GDP in Chapter 21. Here, well look at
the other two.

22.3 NOMINAL AND REAL VALUES

Nominal and Real Wage Rates

Nominal wage rate is the average hourly wage rate
measured in current dollars.

Real wage rate is the average hourly wage rate

measured in the dollars of a given reference base year.

22.3 NOMINAL AND REAL VALUES

To calculate the real wage rate, we divide the nominal
wage rate by the CPI and multiply by 100.
Nominal wage rate in 2006
Real wage rate in 2006 =

Real wage rate in 2006 =

x 100

CPI in 2006

RM50
x 100 =RM48.26
103.6

The RM48.26 amount is in 2005 ringgit.

22.3 NOMINAL AND REAL VALUES

Figure 22.4 shows
nominal and real wage
rates: 19822006.
The nominal wage rate
has increased every
year since 1982.
The real wage rate
decreased slightly from
1982 through the mid1990s, after which
increased slightly.

22.3 NOMINAL AND REAL VALUES

Nominal and Real Interest Rates

Nominal interest rate is the percentage return on a
loan expressed in ringgit.
o Deposit RM100 in saving account
o Nominal interest rate is 5% per year
o Interest return is RM5
o Earn RM105

22.3 NOMINAL AND REAL VALUES

Nominal and Real Interest Rates
Real interest rate is the percentage return on a loan,
calculated by purchasing powerthe nominal interest rate
adjusted for the effects of inflation.
o Deposit RM100 in saving account
o Nominal interest rate is 5%, earn RM105
o Price increase 3%, need RM103 to buy what RM100
would have bought (purchasing power has decreased)
o Actual or real interest earn is 5% minus 3%
Real interest rate = Nominal interest rate Inflation rate.

22.3 NOMINAL AND REAL VALUES

Figure 22.5 shows real
and nominal interest
rates: 19672007.
During the 1970s,
the real interest rate
became negative.
The nominal interest
rate increased during
the high-inflation 1980s.