Question

Price Level & inflation

•   Definition of the Consumer Price Index and the GDP deflator

• Calculation of price index (e.g., CPI, GDP deflator)

• Calculation of inflation (Note: inflation is the rate of change in a price index from one year to another)

• Limitation of the CPI (e.g., commodity substitution bias, quality bias, new goods bias, outlet substitution bias)

Answer 1

CPI or consumer price index is a price index which calculates changes in price level of an average market basket of goods consumed by a consumer

GDP deflator measures price changes of all new, domestically produced goods in an economy

CPI is calculated as: (Cost of basket in current year) / (cost of basket in base year) x 100

GDP deflator = (Nominal GDP / Real GDP) x 100

Inflation is calculated as:

Inflation = (CPI n+1 - CPI n) / CPI n

Inflation = (GDP deflator n+1 - GDP deflator n) / GDP deflator n

This means inflation is calculated as % change in either CPI or GDP deflator over the past year

Limitations of CPI:

• It does not take into account all goods and services, but only an average market basket consumed by consumers
• It does not take into account new goods produced in the economy
• It ignores any qualitative improvements in the goods produced
• It ignores the fact that consumers substitute one good for another in case of price change. The other good consumed is not included in CPI calculation

All these factors make CPI a poor measure of inflation.