Chapter 21: Measure the Cost of Living
The Cost of Living refers to how much money people need to maintain certain standards of
living in terms of goods and services they can afford to buy. Taking a snapshot of prices of
goods and services in an economy at a particular point in time gives the price level. To see
how the price level changes we need to find some way of turning money figures into
meaningful measures of purchasing power. The Consumer Price Index does that. CPI is
used to monitor changes in the cost of living over time. Inflation is to describe a situation in
which the economy’s overall price level is rising and deflation when the overall price level is
falling. The inflation rate is the percentage change in the price level over the previous period.
The Consumer Price Index
The Consumer Price Index (CPI) is a measure of the overall prices of the goods and
services bought by a typical consumer.
How the CPI is Calculated
1. Fix the basket: The first step to computing the CPI is to determine which prices are
most important to the typical customer, if the typical customer buys more salads than
burgers, then salad price is more important therefore should be given greater weight
in measuring the cost of living.
2. Find the price: Now we need to find the price of each of the goods and services in the
basket for each time point.
3. Compute the baskets costs: Then we need to calculate the cost of the basket of
goods and services at different times. We need to keep the quantity the same and
only the price will change to isolate the effects of price changes from quantity
The Cost of Living refers to how much money people need to maintain certain standards of
living in terms of goods and services they can afford to buy. Taking a snapshot of prices of
goods and services in an economy at a particular point in time gives the price level. To see
how the price level changes we need to find some way of turning money figures into
meaningful measures of purchasing power. The Consumer Price Index does that. CPI is
used to monitor changes in the cost of living over time. Inflation is to describe a situation in
which the economy’s overall price level is rising and deflation when the overall price level is
falling. The inflation rate is the percentage change in the price level over the previous period.
The Consumer Price Index
The Consumer Price Index (CPI) is a measure of the overall prices of the goods and
services bought by a typical consumer.
How the CPI is Calculated
1. Fix the basket: The first step to computing the CPI is to determine which prices are
most important to the typical customer, if the typical customer buys more salads than
burgers, then salad price is more important therefore should be given greater weight
in measuring the cost of living.
2. Find the price: Now we need to find the price of each of the goods and services in the
basket for each time point.
3. Compute the baskets costs: Then we need to calculate the cost of the basket of
goods and services at different times. We need to keep the quantity the same and
only the price will change to isolate the effects of price changes from quantity
