Flashcards in Lecture Four Assessable Notes Deck (11):
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.
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.