Chapter 16

How is CPI calculated?

1. Fix the basket (using the quantities of the base year). 2. Find the prices in the year analyzed. 3. Compute the basket's costs using the quantities of the base year and the prices of specific years. 4. Choose a base year and compute the index. 5. Compute the inflation rate.

What are the problems related to CPI?

1. It does not take into account consumers' ability to substitute towards goods that become relatively cheaper over time. 2. It does not take into account increases in the purchasing power of the dollar due to the introduction of new goods. 3. It is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation.

How can CPI be used to measure inflation?

Inflation rate in year 2 = [(CPI in year 2 - CPI in year 1)/(CPI in year 1)] x 100

What is the difference between GDP deflator and CPI?

The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. As a result, imported goods affect the CPI but not the GDP deflator. In addition, while the CPI uses a fixed basket of goods, the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes.

What is the indexation and when do we use it in the economy?

The automatic correction by law or by contract of a dollar amount for the effects of inflation Used to correct the effects of inflation when comparing dollar figures from different times; used in various laws and private contracts and partially in tax laws When some dollar amount is automatically corrected for changes in the price level by law or by contract, the amount is said to be indexed for inflation.

Corrections for inflation on interest rates

The nominal interest rate is the interest rate usually reported; it is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. Real interest rate = nominal interest rate - inflation rate

Consumer price index (CPI)

a measure of the overall cost of the goods and services bought by a typical customer CPI = (price of basket in current year/price of basket in base year) x 100