İktisada Giriş II Measuring the Cost of Living Chapter 2 4 : Measuring the Cost of Living In this chapter we are going to learn one way of measuring inflation. In the last chapter, we have already learned GDP Deflator. In this chapter, we will learn how to calculate the Consumer Price Index . Show the CP I Index numbers (both the table and the graph) and Inflation for Turkey between 198 8 and 2005 in tufe-endeks.xls . Here, CPI measures the average price levels by taking 1987 price level as 100. Inflation based on CPI is the percentage change in the CPI inde x numbers. The data is reported monthly. There are other indices used for measuring inflation such as Wholesale Price Index or Producer Price Index . Show the Wholesale Price Index (TEFE) numbers for Turkey in 1950-2004TEFE.xls . These index numbers take th e value of 100 in the base year 1963. What is the difference between WPI and CPI? The two indices are based on DIFFERENT BASKETS of goods. WPI measures a more general price level. CPI focuses on what average consumers buy. 1COMPARING GDP Deflator vs . CPI: SHOW GDP Deflator vs. CPI for Turkey. PROBLEMS IN MEASURING CPI: SUBSTITUTION BIAS: For example, assume that 2005 price s of 1lt. benzene is 2 YTL and 1 lt. LPG is 1 YTL. We included 30 lt. benzene and 20 lt. LPG in our basket in 2005. Then, in 2006 , price of LPG did not change but price of benzene became 3 YTL. What is the consumer ’ s reaction? Consumers will buy less benzene and more LPG. But our basket did not change in 2006: 30 lt. benzene and 20 lt. LPG. Remember : w e must fix the basket in order to calculate CPI. Then, the inflation we are calculating overestimates the true inflation. That is, CPI ignores the consumer ’ s reaction to the fact that benzene became relatively more expensive than LPG. In 2005, the basket costs 30*2 + 20*1 = 80 YTL . In 2006 the basket costs 30*3 + 20*1 = 110 YTL . If we take 2005 as base year, 2006 CPI = (110/80)*100 = 137.5. So we estimate the 2006 inflation a s 37.5 %. But assume the average consumer consumed 20 lt. benzene and 40 lt. LPG in 2006. Then, his total cost wi ll be 100 YTL. So the true 2006 CPI = (100/80)*100 = 125 and the inflation rate is 25%. But TURKSTAT cannot change the basket every month or year, it is impossible to do t his . So they OVERSTATE or OVERESTIMATE the true inflation rate. Estimated inflation > True Inflation. 2