Question

1. Explain briefly what the consumer price index is trying to measure and how it is constructed.

2. Henry Ford paid his workers $5 a day in 1914. If the U.S. consumer price index was 10 in 1914 and 195 in 2005, how much is the Ford daily paycheque worth in 2005 dollars?

3. Describe the three problems that make the consumer price index an imperfect measure of the cost of living.

4. If the price of a military aircraft rises, is the consumer price index or the GDP deflator affected more? Why?

5. Explain the meaning of nominal interest rate and real interest rate. How are they related?

Answer 1

Q1).

As we know that consumer consumes goods and servives to satisfy his unlimited wants. Consumer price index measures the overall costs of all the goods and services a consumer buys. The Consumer Price Index (CPI) is a measure of the average change overtime in the prices paid by urban consumers for a market basket of consumer goods and services.

The consumer price index tries to measure the overall cost of the goods and services bought by a typical consumer. It is constructed by surveying consumers to fix a basket of goods and services that the typical consumer buys, finding the prices of the goods and services over time, computing the cost of the basket at different times, and then choosing a base year. To compute the price index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100.

The index is calculated by taking the price of the basket in one year and dividing it by the price of the basket in another year. This ratio is then multiplied by 100. The base year is always 100.

CPI = Price of goods and servives in current year / Price of goods and services in base year X 100.

Q2). The given information is

Since Henry Ford paid his workers $5 a day in 1914 and

the consumer price index was 10 in 1914 and 195 in 2005,

then the Ford daily paycheque was worth $5 195/10 = $97.50 a day in 2005 dollars.

Q3).  The Consumer Price Index (CPI) is a measure of the average change overtime in the prices paid by urban consumers for a market basket of consumer goods and services.

The three problems in the consumer price index as a measure of the cost of living are:

(1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive.

(2) The introduction of new goods, which are not reflected quickly in the CPI and

(3) unmeasured quality change.

Q4). As we know that, If the price of a military aircraft rises there is no effect on the consumer price index, since military aircraft are not consumer goods. But the GDP deflator is affected, since military aircraft are included in GDP as a part of government purchases.

Q5). The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation.

Real intrest rate = Nominal interest rate - Rate of inflation.

Hope you got the answer.

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