Cost of Living

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Measuring the Cost of Living


Last time we discussed the most important measure of economic well-being – real, per capita GDP. Further, if we want to see how our economic well-being is changing over time, we can calculate how real GDP is changing in percentage terms (for example, real GDP grew 4% last quarter).

Now, we turn our attention to another important measure of the economy.

We want to measure how the cost of living changes over time.

The main intuition here is that, over time, peoples’ incomes and the prices of goods and services increase. 30 years ago an ice cream sundae cost $1 and a typical economics professor earned $35,000. Now, a (bad) ice cream sundae costs $4.50 and a typical economics professor
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We have to figure out what a “typical” consumer buys. Imagine a shopping cart – you fill it up with items that a typical consumer will purchase.

Step 2: Find the prices:

Now that we have our basket, we can track prices on the items in the cart and see how much it all costs.

Step 3: Compute the cost of the basket:

Let’s determine the cost of the basket from year to year

Step 4: Choose a base year, and compute the index:

Pick a year to serve as a benchmark – a comparison basket cost for all other years. We then can use the cost in benchmark year (called a “base year”) relative to the cost of the cart in the year we are interested in to calculate a cost if living index.

Step 5: Compute the inflation rate:

This is easy: just calculate how the index changes from year to year in percentage terms.

To see these steps in action, consider the following example (from the textbook):

Step 1: Fix the basket:

Well, suppose that what we see consumers typically buying are 4 hot dogs and 2 hamburgers – that is what is in their shopping cart…

Step 2: Find the price of each good in each year:

This is just observing prices every 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 in each year:

Let’s see how much the stuff in the cart costs from year to year…

Year: Cost of basket:
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