Question

The Consumer Price Index (CPI) is one of the most important economic variables that we look at. Why is it so important? In what ways does it impact economic activity and the choices policymakers face?

Discuss some shortcomings or issues with the way we calculate CPI. What suggestions do you have for addressing these?

Answer 1

1.The Consumer Price Index is a monthly US market indicator for most household goods and services. It tracks inflation, or rising prices, and deflation, or price declines. The CPI tracks inflation, which is one of the main challenges to a stable economy. If your income doesn't keep up with rising costs, it eats away at your living standards. It increases your cost of living over time. If the rate of inflation is high enough, that will hurt the economy. Manufacturers make less, since it costs more. They are, in the end, forced to lay off jobs.

The Federal Reserve uses the CPI to determine whether we need to modify economic policies to prevent inflation. The Fed uses contractionary monetary policy when it acknowledges inflation to slow economic growth before inflation develops. It does change the rate of fed funds. Which makes the loans more costly. It tightens the supply of money which is the total amount of credit permitted to reach the market. Actions by the Fed reduce the financial system's liquidity, making it more costly to get loans. It is slowing economic growth and demand, placing downward pressure on prices. That brings the economy back to a healthy growth rate of 2 to 3 percent per annum.

2. As for all economic indicators, the Consumer Price Index is a faulty estimate of the cost of living. This doesn't mean it doesn't make any sense, as long as we note the flaws. Both the CPI and the core inflation index are relevant because they serve different audiences. The CPI helps households grasp their total living costs from month to month, while the core inflation index is a preferred metric from which to make major adjustments to government policy.

In recent years, the statisticians have paid considerable attention to a subtle problem: that increasing the overall cost of purchasing a fixed basket of products and services over time is conceptually not quite the same as increasing the cost of living, since the cost of living reflects how much it costs a person to believe that their consumption offers an equivalent degree of satisfaction. Thus, substitution bias — the increase in the price of a fixed basket of products over time — appears to overstate the increase in the true cost of living of a customer, as it does not take into account that the individual may substitute products whose relative prices have risen away. The flip side is that the CPI tends to understate consumers’ standard of living, as measured by nominal income/CPI.