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Measuring The Cost of Living- Chapter 6.docx

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Serge Nadeau

Measuring The Cost of Living The Consumer Price Index (CPI) Is a measure of the overall cost of the goods and services bought by a typical consumer Price of basket in Current year x 100 Price of basket in base year How it is calculated 1. Determine the basket 2 shots, 4 beers 2. Determine the prices 1$ 2$ 2$ 4$ 3. Compute basket’s cost 2x 1 + 4x2 = 10$ (base year) 2x2 + 4x4 = 20$ 4. Choose a base year and compute CPI ( 20$/10$) x 100 = 200 5. Compute Inflation rate (20$ - 10$/20$) x 100 = 50% Percentage change in CPI from preceding period *Core inflation is the measure of the underlying trend of inflation What is in the basket?  Problems in Measuring CPI 1. Commodity Substitution Bias ( CPI ignores the possibility of substitution when prices rise/fall) 2. Introduction of new goods (Greater variety increases the value of a dollar and choices) 3. Unmeasured quality change (quality increase increases value of a dollar) GDP Deflator vs. CPI 1. GDP deflator reflects the prices of all goods and services produced domestically, where as CPI measures all products bought by consumers 2. CPI compares a fixed basket
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