Chapter 24: Measuring the Cost of Living

Chapter 24 is about measuring the costs of living. Each year the Bureau of Labor Statistics calculates the consumer price index through five steps: fixing the basket, finding the prices, computing the cost of the basket, choose a base year and compute the index (price of basket in current year/price of basket in base year x 100) and the computing the inflation rate (CPI in year 2 - CPI in year 1/CPI in year 1 x 100).

The Bureau also calculates the producer price index, which is a measure of the cost of a basket of goods and services bought by firms.

There are several problems in measuring the cost of living. The first problem is called substitution bias, meaning that consumers substitute towards goods that have become relatively less expensive. Another problem is the introduction of new goods. This means that when a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being. The third problem would be unmeasured quality change, meaning that if the quality of a good deteriorates from one year to the next while its price  remains the same, the value of the dollar falls since people are getting a lesser good for the same amount of money.

Interest rates are also relative to CPI because we consider both the interest rates and changes in prices in computer how much a person earns in a savings account. The interest rate that measure the change in dollar amounts is called the nominal interest rate and the interest rate that has been corrected for inflation is called the real interest rate. The real interest rate is computed by subtracting the inflation rate from the nominal interest rate.