Question

Describe the steps involved with measuring inflation.

Identify and briefly describe the 2 main 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

Below are the steps involved with measuring inflation:

1. First define a fixed basket of goods and services that will be used to calculate an index (Such as CPI) over the years. The fixed basket will be used to compute the amount of money the consumer spends across the years.

2. Now find the price of all the goods and services. Multiplying the fixed basket of goods and services by the market price in the relevant time period, will give us the cost of that basket for each time period.

3. Now, the base year must be chosen and the index be computed by dividing the each year's basket cost by base year's cost and multiplying it by 100.
For base year, the index will be 100 and it will change for other years unless the overall cost of basket stays constant. One can then find the inflation rate by looking at how the index is changing over the year.

The two problems that can arise by measuring price levels with a fixed basket of good are:
a. Substitution bias: It is always possible that the consumer may substitute higher priced goods for lower priced goods. Overall the fixed basket may not represent the true inflation rate in the economy.

b. Quality changes are also not captured by such indices. While the price of specific goods might change over time, so can the quality of the goods. However, such a change might not be reflected by the indices.

One can always build alternative indices that addresses these issues and can provide a realistic inflation measure.