The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point.
Full Answer
What factors can affect the accuracy of the CPI?
Match the situation to the factor that affects the accuracy of the CPI. New pop-up stores at airports sell clothing, personal electronics, and designer eyewear at low prices. (new locations) The cost of bananas increases dramatically. Many people switch to oranges because they are cheaper. (substitution) The cost of cable increases.
How accurate is the CPI as an indicator of inflation?
Although the CPI is widely used as the core indicator of inflation, its accuracy in this area has drawn increasing criticism. For example, during a period when energy costs rose by more than 50% and the prices of some of the most commonly purchased grocery items increased by nearly 30%, the CPI continued to show a very modest inflation rate.
What is CPI and why is it important?
A CPI is used not only in the United States but in virtually every other developed nation as well. 1 The release of monthly CPI numbers almost invariably has a significant impact on the financial markets. Unexpectedly high or low numbers can wreak investment havoc.
What are some of the weaknesses of the CPI?
Novelty and innovation represent another weakness in the CPI. Products do not become included in the CPI's basket of goods until they become virtual staple purchases by consumers. So even though new products may represent considerable consumer expenditures, they may still be years away from possible inclusion in the calculation of the CPI.
What are three issues regarding the accuracy of the CPI?
Three problems with the CPI deserve mention: the substitution bias, the introduction of new items, and quality changes.
Why the CPI is inaccurate?
Further, the government makes the assumption that consumer spending habits change as economic conditions change, including rising prices. So if prices rise and consumers substitute products, the CPI formula could hold a bias that doesn't report rising prices. Not a very accurate way to measure inflation.
What are the problems in measuring the CPI?
The biggest problems with CPI include substitution bias, new items added to the basket of goods, and quality changes in goods. Economists often recognize these issues and attempt to explain or remove these problems from the computation.
What factors affect CPI?
The CPI represents changes in prices of all goods and services purchased for consumption by urban households. User fees (such as water and sewer service) and sales and excise taxes paid by the consumer are also included. Income taxes and investment items (like stocks, bonds, and life insurance) are not included.
Which of the following is a valid criticism of the consumer price index CPI )?
Which of the following is a valid criticism of the consumer price index (CPI)? The CPI overstates the actual burden of inflation because people can look around costlessly for cheaper goods when prices increase.
Why is it hard to measure rate of inflation?
Inflation is a measure of changes in the cost of living. It is calculated by using statistics such as Consumer Price index CPI, retail price index RPI. However, the official inflation rate doesn't include every price and some consumers may experience different inflation rates.
What is the problem with the CPI?
4 The economic reality is that when certain goods become significantly more expensive, many consumers find less-expensive alternatives to them. For instance, buying the store brand instead of the name brand, or buying regular gasoline instead of premium grade.
Why is the CPI important?
Because the CPI is purposely constructed with a focus on the buying habits of urban consumers, it has often been criticized as not providing an accurate measure of either prices of goods or consumer buying habits for more suburban or rural areas. While cities are indeed the most important centers of economic production, a large swath of a nation's population still lives outside of metropolitan areas, where prices may be higher due to that distance from the center.
What is the most widely used measure of inflation?
The consumer price index , or CPI, is the most widely used measure of a country's rate of inflation, but it has come under fire as being less than ideal. The CPI measure utilizes a basket of goods methodology, which has several flaws including which goods are included in that basket and the effect of substitution.
What is the CPI in the US?
Weight to Urban Consumption. The Bottom Line. A country's consumer price index , or CPI, is considered one of the most fundamental and critically important economic indicators measuring inflation, not only in the United States but in virtually every other developed nation as well. 1 The release of monthly CPI numbers almost invariably has ...
Why is the price index flawed?
Any pure price index is flawed by the fact it does not factor in changes in the quality of goods purchased. Consumers may gain a net benefit from purchasing a product that has risen in price as a result of significant improvements in the quality of the product and the purposes it serves. But the CPI has no standard for measuring such quality ...
What are the weaknesses of CPI?
Novelty and innovation represent another weakness in the CPI. Products do not become included in the CPI's basket of goods until they become virtual staple purchases by consumers as seen over time. So even though new products may represent considerable consumer expenditures, they may still be years away from possible inclusion in the calculation ...
Is CPI an indicator of inflation?
Although the CPI is widely used as the core indicator of inflation, its accuracy in this area has drawn increasing criticism. For example, during a period when energy costs rose by more than 50% and the prices of some of the most commonly purchased grocery items increased by nearly 30%, the CPI continued to show a very modest inflation rate.
Why is the chained CPI updated?
The chained CPI is updated [blank] in an effort to compensate for the [blank] of new products. The traditional CPI has a strong [blank] bias. The Consumer Price Index (CPI) and the GDP deflator are both price indices, so they both serve as measures of inflation. However, the [blank] uses a smaller basket of goods.
Why does Hector decide not to go to the movies?
Hector notices the cost of a movie increases by 3% and decides not to go because he mistakenly concludes that movies have become more expensive. (money illusion) Because of extremely high inflation, David makes small weekly cash withdrawals instead of large monthly ones. (shoe-leather costs)
Why Was CPI Changed?
- Traditionally, inflation was measured by the increase in a fixed basket of goods and services. The basket would include a haircut from your local barber, a Snickers bar, a new Ford F-150, etcetera; the goods and services included in the index were fixed, and if their price went up, so did the index. The fixed basket of goods and services is a const...
What Changes Were implemented?
- One of the major changes was implementing chain-weighted CPI, which sounds complicated but is actually really simple. Instead of a fixed basket of goods and services, CPI would change as consumer preferences change. Instead of measuring the cost of certain goods, CPI evolved to become a cost of living index (COLI). This sounds great, in theory: our tastes naturally change ov…
How Can I Protect myself?
- Although CPI might not reflect the reality of inflation, this doesn’t mean your personal rate of inflation will be higher. If you are buying your first house and a used car this year, your personal rate of inflation might be really high. Or maybe you haven’t noticed inflation at all, because it either isn’t affecting you or is concealedby smaller packaging and lower quantities. Regardless of how …