Using the chart below, list three strengths and three weaknesses of the Consumer Price Index calculation.
- Fixed basket of goods
- More relevant to the consumer than the GDP deflator
- Approximates the cost of living more than other measures of inflation
- Substitution Bias
- Introduction of New Goods
- Unmeasured Quality Change
- Once your chart is complete, post a response to the following questions”
- What are the characteristics of the items listed as strengths?
- What are the characteristics of the items listed as weaknesses?
- If the CPI is imperfect, why do we use it?
The strengths of the CPI mentioned are comparative strengths of the index as compared to other measures of inflation. Inflation affects the individual consumer the most, since he can feel the brunt of losing value on his dollar every year. The CPI, with its market basket of goods and services bought by consumers, is more expressive of how the cost of living than other measures of inflation such as GDP deflator or the producer price index. This is the main reason why many wage contracts are indexed to the CPI to determine their cost-of-living allowances.
The weaknesses of the CPI are inherent in its nature. All of the three weaknesses are due to the index being computed on a basket of goods that rarely changes. Substitution bias, for example, occurs when the CPI fails to account consumer choice when it comes to similar goods, whose prices might diverge. Introduction of new goods lowers the cost of living, since it adds variety and more value to each dollar. However, this increase is not reflected in the CPI. Unmeasured quality change is inherent to a system that only computes prices and goods, since quality is very hard to quantify.
Despite these weaknesses and imperfections however, the CPI is still very useful for tracking the changes in the cost of living through the years. Although it has many shortcomings, it still the most accurate way of approximating how much value the consumer dollar has lost through inflation. It is one of the best macroeconomic tools that policy makers in the government use to check that inflation is within reasonable bounds, and ultimately protect the consumer.
- Mankiw, N. Gregory. (2003). Principles of Economics (3rd ed.). Southwestern College Publishing.