Chapter 24: Measuring the Cost of Living

The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices n the economy. The percentage change in the consumer price index measures the inflation rate. The consumer price index is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers' ability to substitute toward goods that become relatively cheaper over time. Second, it does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. Third, it is distorted by unmeasured changed in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation. Like the consumer price index, the GDP deflator measures the overall level of prices in the economy. Although the two price indexes usually move together, there are important differences. The GDP deflator differs from CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect consumer price index but not the GDP deflator. In addition, while the consumer price index uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.