Government, Business and Society

Measuring Cost of Living

Module- 2 Macroeconomic Framework

Contents National Income Analysis: Circular flow of Income,

Concepts of national income and measurement. Consumption Function, Investment Function,

Concept of Multiplier and Accelerator, Aggregate Demand & Aggregate Supply National Income Equilibrium, Inflationary & Deflationary gaps, Real Business cycles, Application of above in business and society.

How we calculate overall cost of living?

Converting monetary figures into meaningful purchasing power

Consumer price index Inflation describe a situation in which economys

overall price level is rising. Inflation rate is percentage change in the price

level from previous period.

The Consumer Price Index

Consumer price index (CPI) Measure of the overall level of prices Measure of the overall cost of goods and

services Bought by a typical consumer

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Calculating CPI 1. Fix the basket

Which prices are most important to the typical consumer

Different weight 2. Find the prices

At each point in time 3. Compute the baskets cost

By keeping same basket of goods effects of price changes is isolated

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Calculating CPI 4. Chose a base year and compute the index

Base year = benchmark Price of basket of goods & services in current year Divided by price of basket in base year Times 100

5. Compute the inflation rate

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1001year in CPI

1year in CPI-2year in CPI2year in rateInflation =

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Calculating the Consumer Price Index and the Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

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Calculating the Consumer Price Index and the Inflation Rate: An Example

This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

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The Typical Basket of Goods and Services

This figure shows how the typical consumer divides spending among various categories of goods and services. Economists calls each percentage the relative importance of the category.

Inflation- Other measures Producer price index, PPI

Measure of the cost of a basket of goods and services bought by firms

Changes in PPI are often thought to be useful in predicting changes in CPI

Wholesale price index, WPI Captures the movements in the wholesale prices ; Very

close to the PPI Differs from the PPI to the extent of tax, wholesale

margin and transport cost from manufacturing units to wholesale establishment

Many countries have switched over from the WPI to PPI Because the PPI can track price changes at primary and intermediate stages before it gets built into the finished goods stages

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Problems in measuring the cost of living

Substitution bias Prices do not change proportionately Consumers substitute toward goods that have

become relatively less expensive Overstates the increase in cost of living from one year to

next

Introduction of new goods More variety of goods

Unmeasured quality change Changes in quality

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GDP deflator versus CPI

GDP deflator Ratio of nominal GDP to real GDP Reflects prices of all goods & services produced

domestically Compares the price of currently produced goods

and services to the price of the same goods and services in the base year

CPI Cost of the basket- Reflects prices of goods &

services bought by consumers Compares price of a fixed basket of goods and

services to the price of the basket in the base year

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Two Measures of Inflation

This figure shows the inflation ratethe percentage change in the level of prices as measured by the GDP deflator and the consumer price index using annual data since 1965. Notice that the two measures of inflation generally move together.

Correcting Economic Variables Dollar figures from different times

Indexation Automatic correction by law or contract Of a dollar amount For the effects of inflation DA (Dearness allowance or Cost of living

allowance)

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Amount in today's dollarsPrice level todayAmount in year T dollars

Price level in year T

=

=

Real and Nominal Interest Rates

Nominal interest rate Interest rate as usually reported Without a correction for the effects of inflation

Real interest rate Interest rate corrected for the effects of inflation

= Nominal interest rate Inflation rate

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Interest rates in a typical Economy

Nominal interest rate Always exceeds the real interest rate Economy experiences rising consumer prices in

every year Inflation is variable

Real and nominal interest rates do not always move together

Periods of deflation Real interest rate exceeds the nominal interest

rate

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Real and Nominal Interest Rates

This figure shows nominal and real interest rates using annual data since 1965. The nominal interest rate is the rate on a 3-month Treasury bill. The real interest rate is the nominal interest rate minus the inflation rate as measured by the consumer price index. Notice that nominal and real interest rates often do not move together.

Price Indices in India

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Price Indices: Sources of Data, Base Year, Commodity Composition and Method of Computation

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WPI CPI-IW CPI-AL CPI-RL CPI-Rural CPI-Urban CPI-Combined (Rural +Urban)

GDP Deflators

Source/ Agency Office of the Economic Advisor/ MOI

Labour Bureau/ MOL

Labour Bureau/ MOL

Labour Bureau/ MOL

CSO NAS, CSO

Method Laspeyres Laspeyres Passche Weights allocated on the basis of

Wholesale transactions

Consumer Expenditure Survey Current year quantities First 1958-59

Latest: 2001 First 1956-57 Latest: 1983

First 1983 Latest 1983

NSS 61st round

Weighting diagram

Country-wide, unique

Horizontal summation of weights of centre specific indices

Price Quotations Bulk transactions Purchase price paid by the consumers - Nature of the index

Single, national Weighted average of the centre indices -

Current Base Year 2004-05 2001 1986-87 2010 2004-05

No of items in basket

676 120-360 260 225 250 n.a. All

Major items covered

i)Primary articles ii)Fuel, power, light & lubricants iii)Manufactured products

i)food ii)Pan, Supari, tobacco& intoxicants iii) fuel&light iv) housing v) clothing, bedding & footwear vi)miscellaneous

i i)food beverages & tobacco ii)fuel & light iii) clothing, bedding & footwear iv)miscellaneous

i)food beverages & tobacco ii)fuel & light iii) clothing, bedding & footwear iv) miscellaneous

i)food beverages & tobacco ii)fuel & light iii) clothing, bedding & footwear iv) housing v) miscellaneous

n.a. All items included in the GNP

No. of Centres/Quotations

5,482 78 600 1181 310 1491 Benchmark surveys

Time Lag 2 weeks/ 1 month 1 month 3 weeks 1 month 2 years

Frequency Weekly: Primary articles and Fuel, power, light & lubricants; Monthly: Overall and all sub-heads

Monthly Yearly

Price Indices in India Uses of Price Indices

WPI CPI GDP Deflator

Users RBI, Planning Commission, Other govt org

Govt, Pvt org, NGOs

Researchers Government

Purpose Deflating Macroeconomic aggregates

Forecasting variables for which prices are prime indicators

Working out escalation costs of projects

Social security and welfare allowances CPI(IW) : wage & dearness allowances of workers & CPI (RL) & CPI (AL): Fixing minimum wages

Main Use Estimation of Inflation Dearness Allowances

Deflating Macroeconomic Indicators

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WPI

CPI

GDP Deflator

Users

RBI, Planning Commission, Other govt org

Govt, Pvt org, NGOs

Researchers

Government

Purpose

Deflating Macroeconomic aggregates

Forecasting variables for which prices are prime indicators

Working out escalation costs of projects

Social security and welfare allowances

CPI(IW) : wage & dearness allowances of workers &

CPI (RL) & CPI (AL): Fixing minimum wages

Main Use

Estimation of Inflation

Dearness Allowances

Deflating Macroeconomic Indicators

Price Indices in India WPI Vs CPI

WPI WPI (Overall): available on

monthly frequency WPI (Primary Articles) and WPI

(Fuel Group) available at weekly frequency

Lag of a fortnight Computed on all India basis Coverage of non- agriculture /

manufactured products is better Wider coverage of commodities:

less volatile to relative price

CPI IW Available at monthly

frequency Lag of one month Constructed for specific

centres Some consumer services are

also included Lesser coverage of

commodity: subject to higher volatility

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Price Indices in India

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Government, Business and SocietyModule- 2 Macroeconomic FrameworkSlide Number 3The Consumer Price IndexCalculating CPICalculating CPISlide Number 7Slide Number 8Slide Number 9Slide Number 10Inflation- Other measuresProblems in measuring the cost of livingGDP deflator versus CPISlide Number 14Correcting Economic VariablesSlide Number 16Real and Nominal Interest RatesInterest rates in a typical EconomySlide Number 19Price Indices in IndiaPrice Indices: Sources of Data, Base Year, Commodity Compositionand Method of ComputationPrice Indices in India Uses of Price IndicesPrice Indices in India WPI Vs CPIPrice Indices in India