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Def: It measures the change in price of a fixed market basket of goods and services from one period to another.
CPI an inflatory indicator that measures the change in the cost of a fixed basket of product and services including housing, electricity, transport and food. The CPI is computed through a four-step process: 1. The fixed basket of goods and services is defined. This requires figuring out where the typical consumer spends his or her money. The Bureau of Labor Statistics surveys consumers to gather this information. 2. The prices for every item in the fixed basket are found. Since the same basket of goods and services is used across a number of time periods to determine changes in the CPI, the price for every item in the fixed basket must be found for every point in time. 3. The cost of the fixed basket of goods and services must be calculated for each time period. Like computing GDP, the cost of the fixed basket of goods and services is found by multiplying the quantity of each item times its price. 4. A base year is chosen and the index is computed. The price of the fixed basket of goods and services for each comparison year is then divided by the price of the fixed basket of goods in the base year. The result is multiplied by 100 to give the relative level of the cost of living between the base year and the comparison years. EXAMPLE: Let’s assume a country where consumers purchase only two vegetables carrot and capsicum. According to the procedure defined above fix the basket of goods. A typical consumer purchases 2 kg carrots and 3 kg capsicum in a given period of time so fixed basket is 2 kg carrots and 3kg capsicum. Second step is to find prices for each period of time. Third step is to compute basket cost. The third step is to compute the basket's cost for each time period. In time period 1 the fixed basket costs (2X $1) + (3 X $6) = $20. In time period 2 the fixed basket costs (2X $2) + (3 X $7) = $25 in time period 3 the fixed basket costs (2 X $3) + (3 X $8) = $31. The fourth step is to choose a base year and to compute the CPI. Since any year can serve as the base year, let's choose time period 1. The CPI for time period 1 is ($20 / $20) X 100 = 100. The CPI for time period 2 is ($25 / $20) X 100 =125.The CPI for time period 3 is ($31 / $20) X 100 = 155. Since the price of the goods and services that comprise the fixed basket increased from time period 1 to time period 3, the CPI also increased. This shows that the cost of living increased across this time period.
Advantages and disadvantages of CPI:
The CPI influences the economy in several ways. A high annual percentage increase in the CPI reflects a high rate of inflation. The CPI also determines the percentage of annual increase or decrease in income. The federal government also uses the CPI to adjust Social Security and disability benefits, to determine the income level at which people become eligible for assistance, and to establish tax brackets. In addition, the CPI is often used to compare prices for certain goods within a set of years, and to calculate constant currency values for two points in time. Disadvantages: It changes over time (consumer goods in the 1970s are not the same as they are in the 1990s).It overstates inflation, because it fails to account for improvements in technology. The third problem with the CPI is that changes in the quality of goods and services are not well handled. When an item in the fixed basket of goods is used to compute the CPI increases or decreases in quality, the value and desirability of the item changes.
Laspeyres price index:
Etienne Laspeyres developed a method in the latter part of the 18th century to measure a weighted price index. An index calculated with Laspeyres price index formula measures price changes in relation to the base period’s market basket and thereby fixes the market basket by holding the items in it constant. It calculates what the market basket will cost in the later periods, even if some of the items were no longer purchased. It is calculated as follows:
Advantages and disadvantages: Advantages: This is a statistical device used to measure changes in index numbers over a period of time. The Laspeyres index measures the change in an identical 'basket' of (for example) goods and services over a period. In inflation measures, for example, the prices of staple foods might be considered to be more important in consumer spending patterns than a box of matches. Changes in the price of those items, which feature heavily in everyday spending, therefore can be more accurately reflected in the resulting index. The Laspeyres index uses weights determined in the base year. Disadvantages: Laspeyres price index tends to overstate inflation. The index implicitly assumes that whatever the price changes the quantities will remain the same. In terms of economics theory, no substitution is allowed to take place. Even if goods become relatively more expensive, it assumes that the same quantities are bought. As a result, this index tends to overstate inflation.
Paasche’s price index:
An index calculated with paasche index formula measures price changes for a market basket containing for what customers are purchasing currently rather what they have purchased in the previous period. It can be calculated as follows:
Advantages and disadvantages:
Advantages: This index assumes that consumer taste and preferences change to maintain a constant level of satisfaction and compare the cost of consumer’s current market basket with what it would have cost to buy this basket goods and services in early period. for example, video cassettes played a more important part in spending habits ten years ago than they do today. They have now been superseded by the availability of DVDs. Weightings therefore have to be changed periodically to reflect these changes. A Paasche index will take this into account every year. Disadvantages: Paasche price index tends to understate inflation. The effects of substitution would mean that greater importance is placed on goods that are relatively cheaper now. As a result, this index tends to understate price. The comparison between years is different because the index reflects both changes in price and quantity. The index requires information on the current quantities and this may be difficult or expensive to obtain.
Fisher’s ideal index:
The Fisher ideal index, proposed by Irving Fisher in 1922, gives good approximations to the theoretical or “exact” cost-of-living index and is relatively simple to compute and use. The geometric mean of Laspeyres and Paasche index numbers. Also known as ideal index number. It can be computed as:
Advantaged Advantages: Fisher’s equation seems to b theoretically ideal.Fisher ideal index has the ability to accommodate the effects of substitutions, something the Laspeyres and Paache indexes do not do. A major advantage of Fisher ideal index over other superlative indexes, is its “dual' property, i.e. a Fisher Ideal price index implies a Fisher Ideal quantity index, and vice versa. In other words, the product of a Fisher Ideal price index between two periods and a Fisher Ideal
quantity index between the same two periods is equal to the total change in value (measured in current dollars) between those two periods. Disadvantages:It is rarely used in practice because it has same problem as the paasche index.It requires a new set of quantities be determined for each period.
A value index measures changes in both the price and quantities involved. It shows the change in the sales of goods in current prices compared to the sales of previous periods. Value index is the ratio in percentages of the indicator of the current period and that of the reference period. Price index is not used while calculating the value index.
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