Question

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?

4. How does inflation affect society and who are the losers and gainers from inflation?

5. Define demand pull inflation and cost push inflation.

6. The salary of the president of the United States in 2000 was $400,000. In 1940, the president's salary was $75,000. If the Consumer Price Index was 8.1 in 1940 and 100 in 2000, the 1940 presidential salary measured in terms of the purchasing power of the dollar in 2000 would be:

Answer 1

1) CPI or Consumer Price Index as it is known is calculated to indicate price level in the economy. The CPI is calculated by taking a weighted average of a basket of goods and services. This is compared against the base year value of the same basket of goods and services to measure the inflation or rise in the price level in the economy.
If the current year CPI is 108 and the base year which was the previous year then it could be concluded that CPI has risen by 8% in one year.

2) CPI or consumer price index is the measure of the price level from the base year. It includes the weighted average of basket goods and services. This basket of goods and services is consists of the items generally bought by the consumers and it may include imports also.
The GDP deflator is the ratio of nominal GDP to the real GDP and it includes all the products and services produced domestically. As CPI is concerned with consumer only but GDP deflator includes industrial as well as government purchase of goods and services. Further, as it is related to GDP which means it can not consist of imported items and only domestically produced items is included in that.

3) Inflation is nothing but a rising price level. It erodes the purchasing power of money. For example, if the current year inflation is 5% then the price of a basket of goods and services has increased by 5% this year. If the inflation is higher and growth in income is not matching to that of rate inflation then people will lose money and purchasing power affecting their lifestyle. It has been observed that marginal people in society tend to bear more brunt of higher inflation.
In the financial world, borrowers gain from inflation while lenders bear the losses.

4) Inflation is generally divided into two categories such as demand pull and cost push inflation.

If consumer taste changes and if there is a sudden rise in demand for any product and there is no adequate supply to fulfill the demand then the obvious result is the rise in prices until a new equilibrium is achieved. This phenomenon is known as demand-pull inflation.

If there is a sudden rise in any raw material price or input cost or if it is in a shortage then it increases overall production cost. This scenario is known as cost-push inflation.

5) In 1940, CPI was 8.1 and the salary was $75000.
In 2000, CPI was 100

( 75000 * 100 ) / 8.1 = 925925.925

The salary should be $925925.925