Question

Question 3.

A hypothetical economy produces only four types of goods domestically; food, clothing, housing, machines. The quantities produced and their respective prices are shown below for two different years, namely 2000 (base year) and 2002 (current year)

	Q(2000)	P(2000)	Q(2002)	P(2002)
Food	12	10	15	11
Clothing	15	15	18	18
Housing	14	20	20	28
Machines	20	25	25	28

A. Calculate the inflation rate over the period 2000-2002 based on the CPI measures of the price level.

B. Explain the why CPI measure of inflation overestimate the actual growth in consumer prices by about one percent.

Answer 1

a) For finding the CPI and inflation rate, find the cost of basket of goods using base year prices and current year prices. This can be done by finding the products of price and quantity for all goods and adding them up.

	Q(2000)	P(2000)	Q(2002)	P(2002)	Cost of basket 2000	Cost of basket 2002 at base year level
Food	12	10	15	11	120	132
Clothing	15	15	18	18	225	270
Housing	14	20	20	28	280	392
Machines	20	25	25	28	500	560
Total cost					1125	1354

The last two columns contain information regarding CPI. CPI index for base year is 100 because we have

CPI = Cost of basket in current year (2000)*100/Cost of basket in current year (2000) = 100

Now CPI in current year 2002 = Cost of basket in current year (2002)*100/Cost of basket in current year (2000) = 1354*100/1125 = 120.36

Find the inflation rate using CPI, inflation rate = (CPI 2002 - CPI 2000)*100/CPI 2000 = (120.36 - 100)*100/100 = 20.36% This is the rate of inflation

b) CPI usually overstates the inflation rate since it suffers from many biases like the substitution bias. It measures the changes in prices only and not in the level of production so actual inflation is generally less.