1

Measuring the Cost of Living

Chapter 24

2

Measuring inflation• Inflation is a fact of life: very few exceptions aside,

all economies in the world have some experience with inflation

• A small number of economies, among them Turkey, know very high and persistent inflation

• In this chapter, we take our first shot at inflation

• Explaining inflation will have to wait a little

• Now we shall look into measuring inflation

• We already encountered a measure of inflation with the GDP deflator

• Inflation is usually measured by the use of price indexes such as the Consumer Price Index and the Producer or Wholesale Price Index

3

Consumer price index – CPI • The consumer price index (CPI) is a measure of the

overall cost of the goods and services bought by a typical consumer

• It is used to monitor changes in the cost of living over time by the use of index numbers

• When the CPI rises, the typical family has to spend more TL to maintain the same standard of living

• In Turkey the consumer inflation is measured by Tüketici Fiyatları Endeksi – TÜFE – calculated by TÜİK

• Other institutions, such as the ITO – Istanbul Chamber of Commerce – also calculates indexes to measure changes in cost of living

4

Calculating price indexes• An index is a method for measuring change of a

magnitude constituted by several independent items

• It means adding up the changes in individual items by giving each item a certain weight in the total

• Establishing the weights of different goods and services in CPI is achieved by fixing a basket

• The consumption basket is determined by TÜİKthrough a “Consumer Survey” of the population

• The previous index is based on a consumer survey undertaken in 1994

• All the goods and services consumed by the typical household as observed in the survey during 1994 are in the basket

5

The cost of the basket• TÜİK collects the prices from different retail outlets

about the prices of the goods and services in the basket three times every month

• Thus obtains an average price of the month for each item

• Then multiplies each average price with its weight in the basket and adds them up

• In this way the total cost of filling up the basket in that month is calculated

• By comparing the cost of the basket this month with the previous month, or the same month a year ago, or that of the base period allows the calculation of inflation

6

Calculating CPI inflation• Dividing the cost of the basket this month by the

cost of the basket at base period and multiplying with 100 we obtain the CPI index for this month

Cost of BaskettCost of BasketB

• Dividing the CPI index for this month with that of the previous month, then substracting 1 and multiplying with 100 gives the monthly CPI inflation

CPI indext

CPI indext-1

• The same operation can be done for the same month of previous year to get annual inflation

CPI indext = x 100

CPI inflationt = [ - 1 ] x 100

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Same inflation, different figures• In the short run, the key indicator of inflation is the

monthly figure

• TÜİK publishes on the 3rd day of each month the inflation for the previous month

• Annual inflation compares the change in prices in 12 months

• Year-end inflation is annual inflation for the calender year (January to December)

• Average annual inflation is calculated by taking the average of the annual inflation figures of the last 12 months

• Monthly inflation can be very volatile while average inflation is more stable

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Composition of the CPI basketWEIGHT (%)

CPI 100

Food and Beverages 31,1

Clothing 9,7

Housing 25,8

Houseware 9,3

Health 2,8

Transportation 9,3

Entertainment 2,9

Education 1,6

Restaurants 3,1

Miscellaneous 4,4

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Details of CPI index• TÜİK publishes other details of the CPI index

• Subdivisions of major categories: for exemple “Food and Beverages” is divided into three: Food, Beverages, Cigarettes and Tobacco

• Regional indexes: separate indexes for many cities : Istanbul, Ankara, İzmir, etc.

• Different income groups: wage earners, rural households, etc.

• Developed economies also publish detailed local CPI figures such as “white collar employees in county X”

• Or “CPI excluding food”, “CPI excluding energy”, “CPI excluding rent” etc.

10

Wholesale Price Index• All economies calculate a second inflation index

trying to measure the input costs of businesses called “Producer Prices Index”

• In Turkey it was called the Wholesale Price Index –WPI (Toptan Eşya Fiyatları Endeksi – TEFE)

• TÜİK computes a basket of goods used as inputs by the firms in the economy and uses the same base year as the CPI (1994)

• WPI distinguishes between prices of private sector firms and public sector firms

• It has four major categories: agriculture (22.2 %), Mining (2.5 %), Manufacturing (71.1 %) and Energy, Gas & Water (4.2 %)

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Comparing WPI and CPI• CPI includes only final goods bought by consumers;

WPI has only intermediate goods

• Bread, cheese, shirts, socks, skirts, ties are in CPI

• Wheat, flour, milk, yarn, cloth, etc. Are in WPI

• Newspapers, cigarettes are in CPI, print paper and tobacco are in WPI

• 50 % of CPI is services and residential rent

• Eating at a restaurant, going to a movie, visiting a doctor, taking a bus are only in CPI, there are no services in WPI

• Renting a house is in CPI, but renting an office is not in WPI

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Turkey: monthly inflation

0

2

4

6

8

10

12

14

16

Oca.98 Eyl.98 May.99 Oca.00 Eyl.00 May.01 Oca.02 Eyl.02

%

CPI WPI

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Turkey: annual inflation

0

20

40

60

80

100

120

Oca.98 Eyl.98 May.99 Oca.00 Eyl.00 May.01 Oca.02 Eyl.02

%

CPI -Annual WPI-Annual

14

Turkey: average and annual CPI

20

40

60

80

100

120

140

1987 1989 1991 1993 1995 1997 1999 2001

%

CPI Annual CPI -Average

15

Turkey: average and annual WPI

20

40

60

80

100

120

140

160

1987 1989 1991 1993 1995 1997 1999 2001

%

WPI-Annual WPI-Average

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CPI details: February 2002EN YÜKSEK ARTIŞ AYLIK % YILLIK % EN DÜŞÜK ARTIŞ AYLIK % YILLIK %

OTOBAN GEÇİŞ ÜCRETİ 24,6 -58,4 TUZ RAFİNE EDİLMİŞ 1,6 21,1

BALIK 18,8 69,5 TUVALET KAĞIDI 1,6 21,2

KÖPRÜ GEÇİŞ ÜCRETİ 16,6 -12,5 KREŞ VE ANAOKUL ÜCRETİ 1,3 29,3

HASTANE YATAK ÜCRETİ 15,6 44,0 PİRİNÇ 1,1 16,4

VAPUR ÜCRETİ 12,0 22,3 BELEDİYE OTOBÜSÜ ÜCRETİ 1,1 13,9

RÖNTGEN ÜCRETİ 11,9 52,9 AYÇİÇEK YAĞI 0,9 9,0

AMELİYAT ÜCRETİ 9,6 49,3 SÜT (UZUN ÖMÜRLÜ) 0,4 22,1

DANA ETİ 5,5 91,8 UÇAK ÜCRETİ 0,3 11,1

BENZİN 5,4 42,8 KÖMÜR ÜCRETİ 0,3 18,3

KADIN BERBERİ 5,1 27,6 SALÇA 0,3 17,4

SICAK YEMEKLER 4,8 46,8 ŞEKER (KESME) 0,2 32,3

ŞÖFÖR EĞİTİM KURS ÜCRETİ 4,1 51,5 PİJAMA (ERKEK) -1,0 30,9

DOLMUŞ-MİNİBÜS ÜCRETİ 3,5 29,8 GREYFURT -1,8 25,1

TÜP 3,4 49,9 AYAKKABI (KADIN) -2,4 35,2

NORMAL EKMEK 3,4 17,0 TAVUK ETİ -2,5 10,5

LİMON 3,2 107,1 TELEVİZYON -4,0 2,8

BÜTANGAZ OCAĞI 3,0 28,8 TAKIM ELBİSE -5,1 46,2

BEYAZ PEYNİR 2,6 32,1 GÖMLEK (ERKEK) -5,5 46,8

SUCUK 2,6 51,9 PALTO -8,9 28,1

BELEDİYE SUYU 2,4 34,9 KAZAK (KADIN) -9,5 40,6

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WPI details: February 2002EN YÜKSEK ARTIŞ AYLIK % YILLIK % EN AZ ARTIŞ AYLIK % YILLIK %

SİVRİ BİBER 168,1 54,1 TELEVİZYON ALICISI (RENKLİ 51 EKRANDAN KÜÇÜK) 0,2 5,2

HAMSİ 76,1 77,2 TOZ DETERJAN 0,1 7,2

MANDALİNA 33,0 103,5 KAMYON VE OTOBÜS DIŞ LASTİĞİ 0,1 17,2

AMONYUM NİTRAT 20,5 15,0 KATKILI PORTLAND ÇİMENTO (KPÇ) -0,3 12,0

PORTAKAL 18,6 62,0 BLOK SÜNGER (POLİÜRETAN KÖPÜK MAMÜLLERİ) -0,4 30,9

HAM PETROL 15,1 89,1 TORNA MAKİNALARI -0,4 22,3

ÜRE 12,9 33,3 OLUKLU MUKAVVA (SAFİHA) -0,8 15,5

HAYVAN SAĞLIĞINDA KULLANILAN İLAÇLAR 11,2 33,9 TELEFON SANTRALİ -0,8 22,8

DOMATES 10,3 13,5 TEMİZLİK KAĞITLARI (KAĞIT MENDİL DAHİL) -0,9 20,1

KOMBİ 9,5 42,7 KONTRAPLAK -1,1 19,4

DEMİR KÜTÜKLER 8,9 65,7 SACLAR (3 mm ALTINDA) -1,2 60,3

KALORİFER YAKITI 8,3 67,0 HAVA VE VAKUM POMPALARI, KOMPRESÖRLER -1,3 44,4

MOTORİN 7,4 57,2 PARAKSİLEN -1,8 185,2

SÜPER BENZİN 6,5 45,1 TAKSİMETRE -1,8 22,2

EV TİPİ BUZDOLABI (155 AYAKTAN DAHA YUKARISI)5,5 26,9 BAKIR -1,8 22,2

POLİVİNİL KLORÜR (PVC) 5,1 72,2 GREYFURT (ALTINTOP) -4,2 83,4

TRAKTÖR (35-50 HP ARASINDA) 4,8 32,1 ATEŞ TUĞLA (% 70 DEN FAZ.ALÜMİNYUM İHTİVA EDEN)-4,9 85,0

STEYŞIN OTOMOBİL (BENZİNLİ) 4,2 30,2 KURU SARMISAK -9,4 10,5

EKMEK 4,1 24,8 KROM -12,0 21,7

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Problems in measuring inflation• Indexes are accurate measures of the selected goods

and services that make up the typical bundle, but they are not necessarily perfect measures

• The basket may misrepresent reality

– 1994 was a crisis year in Turkey with unusually low spending for many items

– CPI has a high weight for rent (20 %) but rented housing is not widespread in Turkey

– Agricultural goods introduce volatility toWPI

• There are also systematic problems with indexes

– Substitution bias

– Introduction of new goods

– Unmeasured quality change

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Substitution bias and new goods• Substitution bias: once fixed, the basket does not

change to reflect the reaction of consumers to changes in relative prices

• Consumers substitute towards those goods that become relatively less expensive

• The index overstates inflation by not considering this substitution by consumers

• Introduction of new goods: again the basket does not include goods introduced after base year

• Often, the price of new goods fall very fast in early days: like mobile phones and computers

• Changing the basket as often as possible, ideally every year, solves these problems

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Unmeasured quality changes• If the quality of the good rises from one year to the

next, the real value of our money increases even if the price of the good remains constant

• Alternatively, the price of good may rise from one period to another but with a corresponding improvement in quality

• Measuring quality changes is an even more difficult problem for services such as health care

• Think of a new bus service with air conditioning but higher price: is it inflation or better service?

• Research in the US found out that CPI overstates the increase in cost of living by about 0.5 to 2 percentage points per year

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CPI and the GDP deflator• Economists and policymakers use both the CPI and

the GDP deflator to analyse inflation

• There are important differences between the two

• Consumer Price Index

– includes only consumer goods,

– includes imports

– is measured using a fixed basket

• Gross Domestic Product deflator

– includes all goods and services domestically produced

– excludes imports,

– is measured using currently produced goods and services

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Turkey: CPI, WPI and GDP deflator

30

50

70

90

110

130

1987 1989 1991 1993 1995 1997 1999 2001

%

CPI -Average WPI-Average GDP Deflator

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Correcting for inflation• You often hear parents saying something like “we

bought this flat for 150.000 TL in 1970” and wonder about how much it was worth today

• Even at low leves of inflation such as 2-3 % per year, over long periods of time the purchasing power of money changes substantially and needs to be corrected for comparaisons

• Price indexes are used to make this correction by inflating the original price to current prices

Price Index2002

Price Index1970

Price2002 = Price1970 x

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Indexation• Price indexes are widely used in the economy to

correct for the effects of inflation

• If a payment is automatically corrected for inflation by contract or by law, the payment in question is said to be indexed to inflation

• The government indexed pensions of Social Security (SSK emeklileri) to CPI: it means pensioners automatically get an increase equal to the CPI change of previous month

• The tax system is also indirectly indexed to annual inflation with changes in tariffs

• High inflation countries have developed sophistic-ated indexation systems but not in Turkey

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Real and nominal interest• It is very important to correct interest rates for

inflation

• Nominal interest rate is the actual interest rate that we see in the market place

• Real interest rate is corrected for inflation

• Assume nominal interest rate is 70 % p.a. and annual CPI inflation is 50 %

• For 1 billion TL, after one year you get 1.7 billion TL with interest but your 1 billion TL has in the meanwhile became 1.5 billion TL with inflation

• Your real interest is only 200 million TL, the rest of the interest you received (500 million TL) goes to offset your loss from inflation

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Calculating real interest rate• How do you calculate the real interest rate?

• For low inflation (below 10 % p.a.) a simple rule is:

Real interest rate = nominal interest rate –inflation

• For example, if inflation is 3 % and the nominal interest rate is 6 %, the real interest rate is 3 %

• At higher inflation this rule is not applicable.

• Let us call r = real interest rate, i = nominal interest rate and = inflation rate, all in percentages

• The full formula becomes:

r = [ (1 + i / 1 + ) – 1 ] x 100

• For i= 70 % and = 50 % we get r = 13.3 %

r = (1.7 / 1.5) – 1 = (1.13 – 1) x 100 = 13 %

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1965

Interest Rates(percent per

year)

15

Real interest rate

10

5

0

-51970 1975 1980 1985 1990 1995

Nominal

interest rate

US: nominal & real interest

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Turkey: nominal & real interest

-30

0

30

60

90

120

150

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

%

-30

0

30

60

90

120

150

180%

Real Rate ( WPI) Real Rate (US$) Int.Rate on Dom.Bor.(ave.comp.)

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Conclusion• Inflation is measured by the price indexes

• Indexes work by comparing the total cost of a basket of goods and services during one period with the cost at a base year

• In Turkey, TÜİK calculates two major price indexes

• Consumer Price Index – CPI (Tüketici Fiyatlari Endeksi – TÜFE)

• Producer Price Index – PPI (Üretici Fiyatları Endeksi – ÜFE)

• The base year for the both was 1994 when a consumer survey has established the weights

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Conclusion• Indexes are not perfect measures

• The accuracy of price indexes are limited by

– errors of base year or basket composition,

– substitution bias

– the introduction of new goods

– quality changes in products

• CPI is used in order to compare purchasing power in two distant periods

• By inflating the old price to current price level

• Nominal interest rates need to be adjusted for inflation

• To obtain real interest rates