Question

1. Carefully define Consumer Price Index (CPI). How is the CPI used to measure the economy’s performance? What flaws and/or pitfalls are there in the measure?

Answer 1

Definition and Formula of CPI:

The Consumer Price Index (CPI) measures the weighted average of prices of a basket of goods and services consumed by households. CPI is calculated using price changes from each item in the predetermined basket of goods. Changes in CPI are used to assess the cost of living in a country.

The formula of CPI is given by:

CPI_t = C_t/C₀ * 100

where, CPI_t = consumer price index in current period

C_t = cost of market basket in current period

C₀ = cost of market basket in current period

Uses of CPI:

The CPI is an economic indicator used to determine the inflation or deflation in the economy. It gives an idea of the performance of the government's economic policy. The CPI indicates the price changes in the economy to the households and businessmen and helps in making decisions about the economy.

Limitations of CPI:

1. CPI has been criticized for both upward bias (overstating inflation) and a downward bias (understating inflation).

2. The basket of goods considered in CPI does not include all production or consumption goods in the economy.

3. CPI does not differentiate consumption habits of consumers on the basis of demographics characteristics i.e. urban and poor.

4. CPI doesn't include innovation in the economy. Products do not get included in the CPI's basket until they become common purchases by consumers over time.