Monday, January 28, 2013
Econ 1BB3 – CPI & Interest Rate
Example: Your father earned $40,000 earned in 1982. What is this salary worth in 2012 dollars?
o CPI (1982) = 61.8
o CPI (2012) = 116.3
o Base year CPI is always 100
o Answer: 116.3/61.8 = x/40 000
o X = 116.3 x 40 000 / 61.8 = $75 275
Problems with CPI Indexing
1. Substitution Bias – Ignores consumer substitution; overstates inflation
2. Introduction of new Goods - CPI is based on a fix basket of goods and services; overstates
inflation. Explanation of why TV prices plummet after a few years
3. Unmeasured quality change – some prices changes reflect quality improvements; overstates
CPI vs GDP Deflator
1. CPI – Goods and services bought by typical consumers.
GDP deflator – reflects prices of all goods and services produced domestically.
2. CPI – Price change, quantities stay fixed
GDP deflator – quantities change, price stay fixed
Ration cost of basket current year / cost of basket base year (CPI)