Question

What are the limitations of using CPI as a measure of the inflation rate?

Answer 1

CPI or Consumer Price Index is treated as one of the most important economic indicators of a country. Monthly releasing of CPI has impact on financial markets of an economy. CPI measures the cost of living of the people in the country or inflation. It is the weighted average price of a basket of consumer goods and services. It is the estimation of price changes in the basket of goods and services.

Consumer Price Index tends to overstate or understate the inflation in the country because of its limitations. The following are the limitations of Consumer Price Index.

• Substitution bias : When the prices of one commodity increases, the consumers may switch to substitute products. CPI does not consider the element of substitution in the index calculation.
• Quality bias : Technological changes leads to quality improvement in the products. With a same amount of money we can buy better items next year. This is especially in the case of electronic products. CPI does not take the quality improvement into consideration. Thus the index will not be accurate.
• Income bias : There may be income effect because of changes in the dietary habits of the people. They may opt high protein items. If the weight of such items are not changed or understated, it will affect the index calculation. This may cause understating of inflation.
• New product bias : Introduction of new products is not considered in CPI. When new products are introduced in the market, the prices of the goods will fall. Such fall in price is not considered in CPI. Then the index calculation will become inaccurate.