Question

Question 8:   

1. What is the consumer price index used for?
2. How does a rise in consumer price index affect a typical family?
3. What does the “substitution bias” in the consumer price index refer to?
4. What is difference between the GDP deflator and the consumer price index?

Please explain all your reasoning and show all your work (including mathematical formulas).

Answer 1

a.

Consumer Price Index (CPI) is used to quantify the prices changes which are related to the cost of living of the consumers.

It is used to measure the rate of inflation. And is treated as the factor of Price Competitiveness in the international markets.

b.

A rise in CPI indicates higher inflation and the family members purchasing power would get low. The prices of goods and services would be higher and the consumers will have to pay more prices for same quantity as purchased earlier.

So, a rise in CPI reduces the real purchasing power of a household

c.

substitution bias refers to a factor that is not generally considered in calculation of CPI. It refers to the change in the taste of the consumer from purchasing an expensive good to buying a cheaper good. The consumer will always shift the consumption from expensive to cheaper goods.

CPI takes into account a "FIXED" basket of goods and services and does not reflect the change in consumption made by the consumers. So, there is always a presence of substitution bias in CPI

d.

GDP Deflator = (Nominal GDP / Real GDP) * 100

Consumer Price Index (CPI) = (Cost of Market Basket in a given year / Cost of Market Basket in base year)*100

GDP deflator only includes those goods which are produced within the domestic territory of a country. However, CPI takes into account the goods price which are imported from foreign

GDP Deflator is the indicator of prices of all goods and services. However, CPI is the indicator of only those goods which are purchased by consumers.

We can say GDP Deflator is a broader concept than CPI

**if you liked the answer, then please upvote. Would be motivating for me. Thanks.