Question

How do you construct CPI? What are the three flaws which make the CPI imperfect? Explain the meaning of nominal and real interest rates. How are they related?

Answer 1

The Consumer Price Index (CPI) is an indicator that measures the average change in prices paid by consumers for a representative basket of goods and services over a set period of time. This index is constructed by choosing a basket of goods and camculating its cost at current year prices. Then one defines the base year and calculate the cost of the basket at base year prices. Lastly the cpi is calculated as the percentage change in the price index from one period to the preceding one. However it suffers from some limitations. Firstly, CPI fails to account for changes in product quality, which can increase the value of goods and the standard of living of consumers. Secondly, new products constantly enter the market, but they don't become part of the basket of goods used to calculate the CPI until they become common consumer goods. As a result, CPI may fail to account for the price chances of new products when estimating inflation. Thirdly, CPI assigns different weight to different types of products. When the price of a certain product increases, consumers may start to buy less of it in favor of some cheaper substitute. Such change in preferences are not taken into account.

The nominal interest rate is the rate of interest which does not take into account the inflation rate. The real interest rate takes into account the inflation rate. Real interest rate is the difference between the nominal interest and inflation rate.