Question

What is the most commonly cited measure of inflation in the United States / Canada and explain how it is calculated? Briefly describe the problems that always arise from measuring price levels with a fixed basket of goods and what steps can be taken to counter these problems.

Answer 1

• Commonly cited measure in USA -

CONSUMER PRICE INDEX - It measures the changes in the market basket of consumer goods and services purchased by household on weighted average basis of prices by a fixed basket that represents goods and services purchased by a family of four

• How to calculate -

​​​​​​​In the very FIRST STAGE : elementary indices are used to tell the prices levels of very similar goods in the same area but a few are also shown by the geometrical mean formula

In the SECOND STAGE : all the elementary indices are used togtger to create an aggregate induce i.e. CONSUMER PRICE INDEX , which is further computed by Laspeyres Index

• Problems that arise from it -

​​​​​​​Substitution bias - substitution happens when the price of one good or service becomes high people tend to substitute it with another that is relatively cheaper ,however in CPI the rise in the price of fixed basket overstate the consumer's true living cost as it does not take the substitution effect

Improved quality bias - now with better quality goods there price levels are bound to rise , however the CPI again overlooks the prices of new or better quality goods which again misrepresents the true living cost and then again it oversate it.

• How to counter it -

​​​​​​​Other mathematical methods can be used to calculate CPI , or the basket of goods used in it can be updated more frequently

However in 2000's, the effect of substitution bias and Improved quality bias has somewhat reduced to 0.5% per year.

To measure inflation , there is trade off between the simplicity and interpretation and working on fixed basket of goods the results are straightforward and but substitution and Improved quality goods problem jump in but if basket is allowed to evolve to shows for former going to lower price goods and for latter to higher price goods the technical detials can be complex but result will be more accurate