Measuring the cost of living

Consumer price index (cpi)= is a measure of all type of products which is bought by normal consumer.

How to calculate cpi

1. fix the basket.

2.find the prices for each part of the time.

3.compute baskets costs for years

4.choose a base year and compute index.

Cpi= current price *100 / base price.

Inflation rate=( cpi 2 – cpi 1 /cpi 1 ) *100

Problems using cpi

1.Substitution bias- when prices changes consumers changes what products to buy and what quantity,
so basket is changing for this time,but cpi doesnts care it.

2.introduction of new goods- when new products arrive consumers have more choice and each dollar
has more value.

3.unmeasured quality change- if the quality rises value of dollar rises because of you can buy better
product for each dollar.

Differences between gdp deflator and cpi

Gdp measures products produced domestically,when cpi measures producsts just bought by consumers.

Cpi uses fixed basket to measure,while gdp deflator measures current products.

Correcting Economic Variables for the Effects of Inflation

Amount of todays dollars= amount in t years * price level now / price level in t years.

Indexation
Indexation is to fix inflation . when products price rises wages are getting smaller,so indexation means
correction to don’t make another loses.

Real and nominal interest rates

Interest rate which measures changes in quantity of dollars is called nominal interest rate. Interst rate
corrected for inflation is real interest rate.

Real interest rate= nominal – inflation.