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Cost of Living

In: Business and Management

Submitted By wildbillcfbc
Words 1983
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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 earns $70,000.

Main Parts of the Notes:

1. How do we measure the cost of living? a. Using the GDP price deflator b. Constructing the Consumer Price Index (CPI) c. Deriving an inflation rate from the CPI 2. How do we adjust for inflation when comparing dollar values over time?

Minor Point:

What are the weaknesses of the CPI as a measure of the cost of living?

Measuring The Cost of Living:

There are two broad measures of the cost of living: the GDP price deflator and the CPI. Both measures move together, so they paint a similar picture of the cost of living. We will briefly discuss the GDP deflator first, and then move on to the more important CPI.

GDP Price Deflator:

Last time we saw how we can calculate both nominal and real GDP. The idea here is to construct a measure (and index to be precise) of the cost of living using this information.

Recall, the only difference between nominal and real GDP is that changes in prices (the cost of living) ARE reflected in nominal GDP but are not in real GDP.

Intuitively, suppose you have the following information:


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