Measuring the Price Level and Inflation

The consumer price index (CPI) is a measure of the "cost of living" during a particular period. The CPI measures the cost of a group of goods and services in a particular period relative to the cost of those same goods or services in a base year. The CPI is a valuable tool for measuring the price level and inflation; it can also be used to adjust nominal economic data - via deflating and indexing - to eliminate the effects of inflation.

Exploration: How can the CPI be used to determine changes in the cost of living?

The applet above illustrates the quantities and prices of a market basket of goods and services purchased by a particular family. The prices and quantities of each of the items can be changed to determine the effects of these changes on the CPI and the inflation rate between the two years. Use the mouse to click on any of the boldfaced price or quantity cells and change the number in the highlighted gray area to a new value; click the Reset button restore the original values.

1. Use the market basket illustrated to compute the consumer price index for this family for each year and calculate the rate of inflation based on this CPI.
   
   
2. Assume that the price of gasoline remained the same from 2001 to 2002 (i.e. change the price of gasoline in 2002 to $1.50). Recompute the family's consumer price index for each year and calculate the rate of inflation based on this CPI. Compare your answers in the two cases.
   
   
3. Reset the table to its original values. Assume that this family responds to the price changes in 2002 by reducing its purchases of hamburgers to 50 hamburgers per month and movie tickets to 8 movies per month, while increasing its purchase of gasoline to 50 gallons per month. What is the actual percentage change in the cost of living for this family after these spending changes? According to the CPI, what is the change in the cost of living for this family? What do you conclude about the CPI, in terms of its ability to measure "true" inflation?
   
   
4. Reset the table to its original values. Suppose this family's income rose from $50,000 in 2001 to $54,000 in 2002. Is this family better off or worse off in 2002, according to the CPI? How much would this family's income need to increase from 2001 to 2002 to maintain its purchasing power between the two years?

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Exercise picked up from the 2e Macroeconomics textbook.