Sanam Barkat - 14195

MACROECONOMICS ASSIGNMENT # 2

Habiba Jawed 14791 Shiza Nasim - 14466

Q. Discuss the limitations and issues in estimating inflation through CPI? The CPI (Consumer Price Index) measures changes in the price level of consumer goods and services purchased by households. CPI is found to overstate inflation; it isnt accurate because of the following reasons: SUBSTITUTION BIAS: When the price of a product in the consumer basket increases substantially, consumers tend to substitute lower-priced alternatives. For example, shelter costs have risen more than 75% while apparel prices have increased only 30%. Households tend to buy less of the items with larger price increases and more of those with smaller price increases. Since the CPI is a fixed-weight price index, it would not accurately predict the impact of the price increase on the consumer's budget. QUALITY BIAS: Over time, technological advances increase the life and usefulness of products. For example, the useful life of automobile tires increased substantially over the past few decades, decreasing the tire cost on a per mile basis, but the CPI does not reflect such improvements. NEW PRODUCT BIAS: New products are not introduced into the index until they become commonplace, so the dramatic price decreases often associated with new technology products are not reflected in the index. After the changes in methods of computing CPI, the bias is now estimated to be below 1 percent. The CPI still overstates inflation but not as much as it once did.
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