Question

Think about your current situation and what happens when prices increase generally. There are several methods that can be used to measure changes in prices but one of the most commonly used method is the CPI.

1. Describe how is the CPI derived and what purpose does it serve?

2. What is the difference between the CPI and the GDP Deflator?

Answer 1

1.A consumer price index (CPI) measures changes in the price level of market basket of consumer goods and services which are used by households. A base year is selected whose CPI is 100. The market basket for the base year commodities is calculated by multiplying the price with quantity. This measure is used to find out the inflation in other years. This is an important for formulating the fiscal policy. The Fed looks at the inflation and announces the interest rates. CPI is published by the Bureau of Labor Statistics, U.S. Department of Labor.

The CPI is used to find out the real wages, how much money can buy now.

2. CPI suffers from the following biases and overstates the inflation.

a. Substitution bias: When goods are substituted the CPI does not reflect the substitution. For example if price of Good A rises and Good B which costs less is substituted, this substitution is not included in CPI calculation. The CPI will overstate inflation.

b. Quality bias: Improvements in quality of goods is ignored, only prices are used for calculation.

c. New product bias: Introduction of new products are not included immediately in the calculation of CPI. It will be done only if they become common household items.

d. Buying habits: CPI may not satisfy everyone’s requirements. The mix of goods vary for people with different income categories. For example, someone at the poverty level may find that CPI does not reflect the correct inflation rate if food prices increase greatly. The inflation rate will be higher than the CPI rate.