Question

The consumer price index (CPI) is used to calculate the rate of inflation, and hence it measures the cost of living in an economy.

1. How do we use consumer price index (CPI) to measure the cost of living? What is the relationship between CPI and the rate of inflation?
2. What is the importance of measuring price fluctuations? How does the change in average price help explain the difference between nominal and real interest rates?

Answer 1

a. The consumer price index is a a measure of the weighted average of the prices of consumer goods and services such as transportation, food and medical care. It takes into account the price changes of the basket of goods and averages them out. Changes in the CPI is used to assess the price changes associated with the cost of living. This is used to identify and measure the inflation and deflation. CPI measures the changes in prices of the basket of goods which is known as inflation.

If the Consumer Price increases the rate of inflation increases as well. Inflation is not always a negative sign, during inflationary periods, Central Banks and the Federal Reserve feels the need to increase the interest rates, in order to compensate for the high inflation rate. With higher interest rates, the currency appreciates and investors are attracted to buy stocks.

b. It is very important to measure the price fluctuations to derive the CPI. The fluctuation in the price has an impact on the expenditures of a household, income tax interest rates, etc which would impact the economy and the calculations of the CPI on a larger scale. If the price fluctuations are not taken into consideration it would not give a true picture of the inflation or deflation in an economy.

A real interest rate is the interest rate that takes inflation into account. This means it adjusts for inflation and gives the real rate of a bond or loan. A nominal interest rate is the interest rate that does not take inflation into account. It is the interest rate quoted on bonds and loan. The change in price affects the purchasing power of an individual, it also affects the real interest rates which in the end affects the CPI and the economy as a whole.If the Prices rise, the inflation also rises and the actual real return is much lower than what was expected.