Question

Table 21.3.2

Data from Southton

	Price (dollars)	Price (dollars)	Quantity (number)	Quantity (number)
Item	Base	Current	Base	Current
Rubber Ducks Beach Towels	1.00 9.00	1.25 6.00	100 12	100 14

1a) Refer to Table 21.3.2. From the data in Table 21.3.2. What is Southton's consumer price index for the current year and what is the rate of inflation over the base year? Show your calculations

1b) When CPI is reported, commodity substitution bias in CPI is not considered. What does commodity substitution bias mean and why does it occur?

1c) What is meant by “core inflation rate” and why does the Bank of Canada consider the core inflation rate?

Answer 1

Answer a

CPI of the Base year =(Price of Rubber(Base) * Quantity of Rubber(Base)0+( Price of Duck(Base) *Quantity of Duck (Base)) / (Quantity of Rubbber (Base) + Quantity of Duck (Base))

= (1*100 + 9*12 )/ (100+12)

= (100+108)/112

=208/112

= 1.857

For CPI in current year only the prices will change quantity for the base year will be considered.

CPI of the Current year =(Price of Rubber(Current) * Quantity of Rubber(Base)0+( Price of Duck(Current) *Quantity of Duck (Base)) / (Quantity of Rubber (Base) + Quantity of Duck (Base))

= (1.25*100+ 6*12)/(100+12)

=(125+72)/112

= 197/112

=1.759

Hence CPI for current year is 1.759

Inflation = (CPI Current - CPI Base)/ CPI Base = (1.759 - 1.857)/1.857 = -0.098/1.857 = -0.053 or - 5.3%

Hence there is a deflation of 5.3% or inflation of -5.3%

Answer b

CPI is calculated with a fixed set of goods/ commodities usually consumed by consumers. Usually when a price of good increases it is a tendency of a consumer to substitute to a cheaper goods and the substituted good is not part of CPI fixed set of goods. Thus CPI is still measured on the same set of goods while the consumers have moved to cheaper substitutes, hence CPI is actually calculated higher. This effect is called Commodity Substitution Bias. It is occuring because CPI is being calculated on the fixed set of goods and consumers are moving to cheaper substitutes.

Answer c

Core Inflation Rate reflects the inflation rate calculated without considering the price fluctuations of the volatile items usually food, energy goods and effect of indirect taxes on prices

Bank of Canada consider the Core Inflation Rate as it reflects the true inflation rate as highly volatile goods will dominate the calculation of inflation rate and may not give the right results