Economics: The Cost of Living

Difficulty: 1/3 (Alright, turns out last chapter was actually hard. This one must be easy)
Review: 4/5 (Looking forward to see what determines a nation's GDP and CPI)

This chapter introduces a new statistic: the consumer price of index (CPI). CPI measures the cost of goods and services bought by a typical consumer, in other words, the cost of living.

Inflation and the inflation rate describe the percentage change of prices from the previous period. Inflation especially is important in macroeconomic performance.

The Bureau of Labor Statistics (BLS) follows 5 steps to find CPI.
-  First, determine the basket. Find which products/services consumers buy and weigh them by the amount each consumer buys of that.
- Then, find the prices of each of the products/services.
- Next, sum all of the costs within the basket.
- Afterwards, choose a base year and calculate the CPI. CPI = (current price of basket / base year's price of basket) * 100
- Finally, compute the inflation rate. Inflation rate = (CPI of year 2 - CPI of year 1)/(CPI of year 1) * 100.

The BLS also calculates producer price index (PPI), which measures the cost of a basket of goods/services bought by firms rather than consumers. Because these costs are eventually passed on to consumers, PPI is thought to be useful in predicting changes in CPI.

There are some flaws in CPI that make its measurement of the cost of living more inaccurate. Substitution bias happens when the BLS doesn't account for consumers switching a product for another product that is cheaper. This makes the calculated CPI higher than the actual cost.
Introduction of new goods give consumers more variety, giving the dollar amount more value. Unmeasured quality change also occurs. If a good deteriorates over time, the value of the dollar falls. In total, these errors cause CPI to show inflation rate overstated by around 1% per year.

The GDP deflator ((nominal GDP / real GDP) *100) is different from CPI because the GDP deflator reflects prices of goods/services produced domestically, whereas CPI reflects goods/services bought by consumers. Thus, CPI doesn't include government purchases unlike the GDP deflator, but does include foreign purchases unlike the GDP deflator. Also, CPI is calculated using a fixed basket of goods compared period to period; however, GDP deflator compares current prices to old ones. Still, turns out the GDP deflator and the CPI have strong association.

Amount in today's dollars = amount in then's dollars * (price level today / price level then). This can be utilized for indexation, a process used to compare dollar values from different times. Many long term contracts between firms and unions include some form of indexation of the wage to CPI. This is called cost-of-living allowance (COLA). Another example is SS benefits, and tax systems, both of whom use indexation.

Banks use a formula, real interest rate = nominal interest rate - inflation rate.

And that's it.