6-Measuring the Cost of Living
The cost of living refers to the value or cost of those G&S, which a
common person uses for his/her living.
The objective of calculating cost of living index is to see whether
incomes of individuals are keeping up with the cost of living
over a given time period.
In other words, the objective is to analyze whether the standard
of living in the country is increasing, decreasing or staying
constant over a given time period.
If the percentage increase in the income of a common person is
greater than inflation rate in a given year, then the standard of
living in that year is said to be increasing and vice versa.
Since the ultimate objective of every government is to achieve
the highest standard of living for its citizens, calculation of cost
of living index is very much needed.
GDP-Deflator vs. Consumer Price Index
Cost of living or inflation rate can be estimated from GDP-deflator
index as we learnt earlier but it is not preferred for two reasons.
One is that GDP-deflator includes all G&S produced in the country
whereas many of them are not purchased by individuals but by
govt. only. For example, only govt. purchases tanks, fighter jets
and nuclear power stations and bears the cost of establishing
and maintaining institutions such as various ministries and
Election and Security Exchange Commissions.
The other is that GDP-deflator does not include imported G&S,
whereas individuals use many imported G&S in their daily life.
For example, individuals purchase imported mobile phones,
cosmetics and medicines.
To take care of these two problems, inflation rate reported in the
media is calculated from Consumer Price Index (CPI) and not
from GDP-deflator index.
Consumer Price Index and its calculation
• deals with the cost of G&S bought by a typical consumer. Its
CPI
calculation requires following steps:
1. Fix the basket: After interviewing a number of individual
households, Pakistan Bureau of Statistics fixes the basket of G&S
that a typical consumer buys. It includes approximately 500
G&S. The number of G&S and the quantity of each remain
unchanged for 5 to 10 years.
2. Find market price of each G&S for each year.
3. Compute the cost of basket for each year.
4. Choose the base-year and calculate index as:
CPI = × 100
5. Compute inflation rate as
Inflation rate = × 100
Typical Basket of Goods and Services
This figure shows how
the typical consumer
divides spending
among various
categories of G&S.
Pakistan Bureau of
Statistics calls each
percentage the
“relative importance”
of the category.
Another example how CPI is calculated
Suppose the base-year is 2002 and the given basket of goods in the base year
costs Rs.1200 and the same basket costs Rs.1236 in 2003 and Rs.1260 in
2004.
Therefore, CPI for 2003 is 103 = (1236/1200)100 and 105 = (1260/1200)100
for 2004.
Inflation rate is 3% = ((103–100)/100)×100 between 2002-03 and 1.94% =
((105 – 103) / 103)×100 between 2003-04
It means that inflation rate or cost of living increased 3% between 2002-03 and
1.94% between 2003-04.
Although CPI accurately shows the G&S which a typical consumer purchases,
yet it is also not a perfect measure of the cost of living because the quantity
and quality of G&S and their number in the basket remains unchanged.
That is, CPI leads to a better measure of inflation than GDP-deflator index
does. Even then, it is not a perfect measure of the cost of living for the
following 3 reasons.
It ignores substitution effect, new goods coming in the market and quality of
same G&S in different years.
Problems of CPI in measuring cost of living
Substitution bias: In reality, consumers substitute more expensive
G&S with less ones in short time but the basket does not change
for 5-10 years to reflect such changes. Hence, CPI overstates cost
of living by considering the prices of originally selected G&S
even if they become relatively expensive.
Introduction of new goods: New products result in greater variety,
which in turn makes each rupee more valuable. It means that
having more variety, consumers require fewer rupees to
maintain the same level of happiness or the same standard of
living. Since new products are not included in the basket for 5-10
years, therefore reported inflation overstates cost of living.
Quality improvement: Quality of G&S usually rises from year to
year, even if their prices stay constant. Since it is difficult to split
a given increase in price into 2 parts, one due to improved
quality and the other due to increase in inflation, therefore total
increase in prices is attributed to rising cost of living.
Illustration of substitution bias
Suppose the chosen basket of G&S for a typical consumer for a period
of 5-10 years includes only red and green apples, 5 of each color. Also
suppose that quality and taste of both colors is identical and the
prices in 2015 (the base year) were Rs.2 per apple for both types. So,
the cost of the consumer’s basket was Rs.20 in 2015.
If, in 2016, the price of red apples increases to Rs.4 while that of green
apples remains Rs.2, then the cost of given basket becomes Rs.30.
It means that CPI for 2015 and 2016 is (20/20)×100=100 and
(30/20)×100=150 respectively and inflation rate between 2015-16 is
[(150-100)/100]×100=50%.
However, a consumer is expected to substitute green with red apples.
That is, he/she buys only 10 green apples leaving his/her cost of
living unchanged whereas inflation rate calculated from CPI predicts
50% increase in cost of living.
It means that in reality, cost of living rises less than what CPI indicates.
GDP-deflator vs. CPI; once again
Computation of GDP-deflator is more laborious than that of CPI because
both the number and quantity of G&S are different in current and base
years whereas they remain unchanged while computing CPI.
GDP-deflator = (market value of all final G&S in current year / market
value of all final G&S in base year) × 100 and
CPI= (market value of G&S in fixed basket in current year / market value
of G&S in fixed basket in base year) × 100
Although computation of CPI is easier, yet determination of the basket of
G&S for a typical consumer is difficult. Economists usually disagree on
its composition and on the number of years after which it should be
changed.
In addition to GDP-deflator and CPI, there are many other price indices
such as Sensitive Price Index (for low-income people), Wholesale Price
Index, Exports’ Price Index and Imports’ Price Index which Pakistan
Bureau of Statistics publishes regularly.
Revision
Explain whether each of the following affects only GDP-
deflator, only CPI, both or none of them.
• An increase in the price of chicken.
• An increase in stock prices.
• An increase in the salaries of government employees.
• An increase in the price of mobile phones.
• An increase in the price of footballs, which are all exported.
• An increase in the price of rifles which Wah Ordinance
Factory sells only to Pak Army and foreigners.
• An increase in the salaries of KFC employees without any
change in KFS burgers in Pakistan.
• An increase in the salaries of Pak workers in Jeddah.
• An increase in vegetable oil imported from Malaysia.
Cost of living adjustment (COLA)
• amount
If of salary in year a is given, one can compute an
equivalent amount for year b to maintain the same standard of
living after applying COLA.
Suppose that in 1950, CPI = 15 and in 2018, CPI = 330 showing that
prices rose 22 times (330/15). This multiple is called COLA for
this period.
If average wage rate in 1950 was Rs.5 per day, then it should be
raised in 2018 to Rs.110 (5×22) to have the same purchasing
power or standard of living as in 1950.
Using COLA, relative expensiveness of different G&S is determined.
Suppose price of mutton was Rs.15 per kg. in 1950 and Rs.900 in
2018 showing 60 (900/15) times increase whereas COLA = 22 for
this period. It means that mutton has become relatively
expensive among consumer G&S over this period.
Indexation and Purchasing power parity or COLA
If in 2010, CPI was 200 and in 2019, it is 300, then Rs.600 in 2010
had the same purchasing power as Rs.900 in 2019.
When a variable such as salaries of government employees or
price of electricity is automatically corrected for inflation by
law or contract, the variable is said to be indexed for inflation.
Salaries in NGOs are usually indexed with inflation.
Similarly, if prices of any G&S is linked with the exchange rate
(ER), then the variable is said to be indexed for depreciation or
appreciation of local currency.
Mostly imported G&S or those G&S which intensively use
imported intermediate and primary inputs are indexed for ER.
For example, ER for US dollar ($/Rs.) was Rs.110 in 2017 which
increased to Rs.154 in 2020. That is an increase of 1.4 or 40%.
Therefore, the price of imported shoes has been raised from
Rs.5000 in 2017 to Rs.7000 in 2020.
Nominal vs. real interest rate
Anyone who lends, deposits or borrows money needs to
distinguish between nominal and real interest rates.
Nominal interest rate is not corrected for inflation whereas real
interest rate is corrected for inflation.
The interest rate mentioned in borrowing & lending contracts is
nominal but the interest rate on the basis of which people
decide to borrow or lend is real.
For illustration, suppose Asad lends Rs.100 to a friend at nominal
interest rate of 15%, so a year later, he will get back Rs.115.
If inflation is 10% over the year, then the real interest rate he
receives is not 15% but 5% (15-10). That is, by lending to his
friend, purchasing power of Asad increases only by Rs.5.
If inflation is 20%, then Asad actually loses Rs.5 in purchasing
power though he receives Rs.115 as per the loan contract.
It means, real interest rate = nominal interest rate – inflation rate
Computation of nominal and real interest rate
A person deposits Rs.2,000 in his savings account, and a year
later he gets back Rs.2,100. Meanwhile, CPI rises from 200 to
204. Compute nominal and real interest rates which the
person receives.
Another person purchases a bond for Rs.920, and a year later he
is paid back Rs.1000. Meanwhile, CPI rises from 500 to 550.
Compute nominal and real interest rates which the person
receives.
Nominal interest rate (i) = real interest rate (r) + inflation rate
(inf). If i is greater than (>) inf, then r is positive but less than
(<) i. It is the common case now-a-days in most of the
countries.
At one extreme, if there is deflation that is inf < 0, then r > i.
At the other extreme, if inf > i, then r < 0 that happens in
developing countries as it is now-a-days in Pakistan.
Summary
GDP-deflator is not a good measure of the cost of living because it
includes many domestically produced G&S which a common
person does not purchase and it does not include any imported
goods, which a common person purchases.
CPI is an imperfect measure of the cost of living for three reasons:
substitution bias, introduction of new goods, and unmeasured
changes in quality.
CPI uses a specific basket of G&S fixed by PBS for 5 to 10 years,
while the GDP-deflator automatically changes the number and
quantity of G&S for every accounting period.
Rupee figures at different points in time do not represent a valid
comparison of purchasing power.
If wages of a certain institution or price of a certain commodity is
linked with inflation, it is said to be indexed for inflation.
Real interest rate equals nominal interest rate minus inflation rate.
