Thursday, October 16, 2008

Limitations of Using the Consumer Price Index (CPI) to Measure Inflation

Limitations of Using the Consumer Price Index (CPI) to Measure Inflation

1. Prices of different products rise at different rates. Consumers tend to shift their consumption away from the more expensive products and substitute cheaper products. Because the CPI uses a fixed basket of goods, it will assume people are still buying the same amount of the relatively expensive products. In reality, however, they are buying less of the expensive products. So their overall expenses are not as large as the CPI suggests.

2. Price indexes have difficulty measuring changes in quality. Consumers benefit from higher quality products. When inflation calculations use a fixed basket of goods, however, the implicit assumption is the quality does not change. A product could be more expensive because it has improved in quality. The CPI would attribute the price rise to inflation.

3. Price indexes have difficulty including new technology. Consumers benefit from new technology, but the fixed basket of goods used in the CPI will not include the newest products and technology. Thus, the CPI is an inaccurate measure of the true cost of living of a typical urban consumer.

The CPI is the primary index used to calculate the inflation rate in the United States. Because of its shortcomings, most economists think the CPI overestimates the inflation rate by 1-2%. This is why the macroeconomic policy goal is low inflation, not no inflation. When the inflation rate is reported around 1.5%, economists feel there in very little real inflation.

2 comments:

  1. Well Done, will help with my exam approaching!

    ReplyDelete
  2. World Price Index :- World Economics is an organisation dedicated to producing insight, analysis and data relating to questions of key importance in understanding the world economy.

    ReplyDelete