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Explain consumer price index (CPI)

CPI is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumption goods and services


How is CPI related to real and nominal GDP

Real GDP we fix price and allow quantity to vary but CPI fixes quantity and allows prices to vary. Because of this we can find the rate of inflation in the economy.


CPI formula

Current year CPI divided by base year X 100

If 2008 is the base year and its CPI is 100 =
50/50*100 = 1*100 =100 CPI

If in 2009 CPI is 140
70/50*100 = 1.4*100 =140


What is the formula for inflation ?

inflation = (new price divided by old price) divided by old price) X 100

(70/50)/50) X 100 = 20/50* = 0.4*100 = 40%

CPI and inflation are NOT the same thing. Inflation can be figured out through CPI. Inflation must be percentage; CPI is whole number or total cost of basket. CPI looks at quantity


Explain inflation and deflation

Inflation: increases in prices over time. Easy example; price rise 2% between 2011 and 2012

Deflation: decreases in prices over time. Easy example: prices fall 2% between 2012 and 2013.


What are sources of bias in CPI?

New goods bias
Quality change bias
Commodity substitution bias
Outlet substitution bias


Explain new goods bias

Every year, some new goods become available and some old goods disappear. Now we have mobile phones we no longer need dial up phones for example. When we compared the prices level of 2015 to 1995 we can not compare the same baskets because today's basket wasn't available ten years ago. Arrival of new goods is believed to put an upward bias on CPI and inflation rate


Explain quality change bias

Cars technology etc get better every year. New additions eg airbags to cars also add new costs. Is the improvement in quality greater than the increase in cost ? CPI probably counts too much of any price rise as inflation thus overstates inflation


Explain commodity substitution bias

Changes in relative prices lead consumers to charge the items they buy. People cut back on items that become relatively less costly. Basically CPI ignores substitution and says that prices have increased when they may not have.


Explain outlet substitution bias

When confronted with higher prices, people use discount stores more frequently and the usual stores less frequently. This phenomenon is called outlet substitution. CPI does not measure outlet substitution.


What are the two consequences of CPI bias

Distortion of private contracts: labor contracts that link wages to the CPI artificially raise wage rates if the CPI is overstated

Increases in government outlays and decreases in taxes: close to a third of federal government outlays are linked to the CPI. If the 1.1 percentage point bias is accurate the government will spend almost a trillion dollars more that it otherwise would have spent over the next decade