Lecture 3 - The Cost of Living
1. Overview
Lecture 2 - Measuring Income and Well-being introduced how economists measure output, income, and prices using nominal and real GDP, GDP per capita, and the GDP deflator.
This lecture extends that discussion by introducing the Consumer Price Index (CPI), the second major aggregate price index used in macroeconomics. It then explains why inflation measurement matters for purchasing power, policy, and long-run economic analysis, before highlighting conceptual and measurement problems with price indices.
1.1 Recap: Inflation
Inflation measures how fast the overall price level is changing over time.
By definition, the inflation rate is the relative change in a price index:
Economic intuition:
- Inflation is not about prices being high or low, but about how quickly they change.
- Inflation can refer to an aggregate index or to the price of a single good.
- Sustained inflation erodes the purchasing power of money.
2. The Consumer Price Index (CPI)
2.1 Definition
The Consumer Price Index (CPI) measures the overall level of prices of goods and services bought by consumers.
Key characteristics:
- Based on the cost of a fixed basket of goods and services.
- Calculated by national statistical agencies such as the Office for National Statistics (ONS) in the UK.
- Designed to approximate changes in the cost of living faced by households.
Economic role:
- CPI is the most commonly cited inflation measure in public debate.
- It plays a central role in monetary policy, indexation, and real income comparisons.
2.2 Calculating the CPI
Step 1: Fix the Basket
The statistical office determines what the typical consumer buys by surveying household expenditure.
Interpretation:
- Goods with higher expenditure shares receive higher weights.
- If consumers spend more on apples than pears, apple prices matter more for inflation.
- The basket is held fixed to isolate pure price changes, not quantity changes.
Exam intuition:
- Fixing the basket ensures CPI measures inflation rather than changes in consumption patterns.
- This is also the source of later measurement problems.
Step 2: Find Prices and Compute Basket Cost
Prices of each item in the basket are collected at each point in time and multiplied by their fixed quantities.
Economic meaning:
- The CPI compares the cost of buying the same bundle of goods across time.
- This ensures that observed changes reflect prices rather than tastes.
Step 3: Choose a Base Year and Construct the Index
The CPI is defined relative to a base year:
Interpretation:
- The base year is normalised to 100.
- CPI values above 100 indicate prices are higher than in the base year.
- Inflation is the percentage change in the CPI between periods.
2.3 CPI and Inflation: A Numerical Example
This example economy contains only hot dogs and hamburgers.
Key intuition:
- Holding quantities fixed allows us to see how rising prices affect total expenditure.
- The CPI translates complex price movements into a single summary measure.
- Inflation reflects how much more expensive the same consumption bundle has become.
Exam tip:
- Be able to compute CPI and inflation mechanically.
- More importantly, explain why quantities are fixed and what that implies.
3. CPI versus CPIH
CPIH is an extension of CPI that includes housing costs.
Key differences:
- CPI excludes owner-occupiers’ housing costs, mortgage interest payments, and council tax.
- CPIH includes these elements.
- CPIH is often seen as a better proxy for the true cost of living.
Policy relevance:
- The UK government and Bank of England primarily target CPI, but CPIH is increasingly referenced.
- Differences between indices matter for benefits, pensions, and real wage calculations.
4. Beyond CPI: Other Price Indices
4.1 Producer Price Index (PPI)
The Producer Price Index (PPI) measures prices of goods and services bought by firms.
Economic logic:
- PPI captures cost pressures earlier in the production chain.
- Rising PPI may signal future CPI inflation as firms pass costs on to consumers.
- Highlights the transmission of inflation through the economy.
4.2 Personal Price Indices
CPI measures inflation for the average consumer.
Interpretation:
- Individual households consume very different baskets.
- Inflation experiences vary widely, especially during periods of high inflation.
- CPI remains informative for policy, even if it does not reflect everyone’s experience.
5. Why Inflation Matters
Inflation has broad macroeconomic consequences.
Key reasons we care:
- Directly affects purchasing power and real incomes.
- Central banks target inflation, for example the 2% CPI target in the UK.
- Inflation influences saving, investment, wage bargaining, and redistribution.
6. Measurement Problems with the CPI
6.1 Substitution Bias
Consumers substitute towards relatively cheaper goods when prices change.
Implication:
- A fixed basket ignores this behaviour.
- CPI may overstate inflation because it assumes unchanged consumption.
- In practice, the UK partially corrects for this using chain-linking.
6.2 New Goods and Quality Change
Two further issues:
- New goods increase choice and consumer welfare but enter the basket with a lag.
- Quality improvements mean higher prices do not always imply higher cost of living.
Economic intuition:
- If goods improve, a pound buys more utility even if prices rise.
- ONS attempts to adjust for quality using hedonic pricing methods.
6.3 Averaging Problem
CPI reflects an average consumer.
Key point:
- Just as with GDP per capita, averages may mask large differences.
- CPI may be irrelevant for specific groups, yet remains crucial for macroeconomic policy.
7. CPI versus the GDP Deflator
The two indices differ in coverage.
GDP deflator:
- Prices of all domestically produced goods and services.
- Relevant for measuring inflation in output.
CPI:
- Prices of goods and services bought by consumers, including imports.
Example:
- A rise in oil prices increases CPI more than the GDP deflator in the UK because oil has a larger weight in consumption than in domestic production.
8. Correcting for Inflation and Indexation
Nominal values must be adjusted for inflation to compare purchasing power across time.
Key concepts:
- A £ today is not equivalent to a £ in the past.
- Indexation automatically adjusts payments for inflation.
- UK pensions are indexed to CPI rather than RPI, reducing government expenditure.
Key Takeaways
- CPI is a fixed-basket measure of consumer prices and inflation.
- It is central to monetary policy, indexation, and real income analysis.
- Measurement problems mean CPI is imperfect, but still indispensable.
- Understanding differences between CPI, CPIH, PPI, and the GDP deflator is exam-critical.
References
Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning.
Office for National Statistics (ONS) (2025) Consumer Price Inflation and the Basket of Goods. London: ONS.
Bank of England (2025) Inflation and Monetary Policy Framework. London: Bank of England.