Question

1. A market basket has three items in 1990, refrigerators that cost $600, washers that cost $300, and stoves that cost $200. In 2017, these items (similar brand, size and quality) cost $1000, $600, and $500, respectively. I decide to say that the base year is 2000 where the costs of these items were $800, $450, and $350, respectively. In each year, people purchased 10 refrigerators, 20 washers and 25 stoves. Calculate the CPI index for 1990 and 2017.

Item Base Year 2000 1990 cost 2017 cost

Refrigerator $800 $600 $1000

Washers $450 $300 $600

Stoves $350 $200 $500

1. The substitution effect is one problem with the CPI. Using data from problem one and from data that you make up, show me why the substitution effect is a problem. Does the substitution effect overstate or understate inflation. Your calculations will show which one.

1. As mentioned above, one problem with the CPI is the substitution effect. Another problem is that taxes are not taken into account. We did not talk about disappearing products (type writers) or products that appear (computers) through time. How do you think these things are accounted for when calculating the CPI?

1. Show me a graph of the business cycle and label it.

Answer 1

	1990	2000	2017
Refridgerator	600	800	1000
Washers	300	450	600
Stoves	200	350	500
CPI for Base Year (2000) is	100

Considering that basket contains

10  Refridgerator

20 Washers

25 Stoves

Market Value of Basket (1990)	17000
Market Value of Basket (2000)	25750
Market Value of Basket (2017)	34500

Using these market values CPI can be calculated

CPI for Base (2000) is 100. So 100 corresponds to 25750 market value of basket

So, according to the market values of basket, CPI's are as follows

CPI (1990)	66.02
CPI (2017)	133.98

Substitution bias occurs when prices for items change relative to one another.

Substitution bias can cause inflation rates to be over-estimated.

When an increase in price of that selected good occurs customers may buy a cheaper substitute

CPI basket may not quickly capture this change.

Adding a new product like computer, or removing an old product like type writer cause bias in CPI calculations.

Such biases can be overcome using Paasche or Laspeyres Index.

These indices keep the past or current basket constant and then calculate CPI.

Fisher index can be more appropriate as it is geometric mean of the two indices stated above.

The highest point here is called as PEAK, while the lowest point as TROUGH as shown below.