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    Consumer Price Index calculation

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    Make a chart that lists three strengths and three weaknesses of the Consumer Price Index calculation.

    Post a response that answers the following questions once your chart is complete:

    o What are the characteristics of the items listed as strengths?
    o What are the characteristics of the items listed as weaknesses?
    o If the CPI is imperfect, why do we use it?

    Please give refrences

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    Solution Preview

    The consumer price index, CPI, is the key gauge for inflation; it measures price increases and decreases on common group of consumer goods and services on a monthly basis. The CPI is calculated by taking a weighted average of price change for a pre-determined group of goods. The goods are weighted in order of their importance. The consumer price index is very similar, but not to be confused with, to the cost of living index which allows for substitutions of the items as prices move higher or lower.
    The BLS, or bureau of labor statistics, publishes CPI data in three main categories: CPI-U (CPI for urban consumers), C-CPI-U (chained CPI for all urban consumers), and CPI-W (CPI for Urban Wage Earners and Clerical Workers). CPI-U, as the name suggests, represents the purchasing habits of consumers in urban or metropolitan areas. CPI-W calculates CPI for a portion of the urban population; the population used in this study requires an urban area to have a minimum of 2500 residents to be considered. Finally, the C-CPI-U is the newest CPI gauge and also the one that is supposed to adapt to consumer needs over time. The basic premise of this measure is that consumers will alter spending habits over time to accommodate for a changing marketplace or more likely a change in price.
    Another key indicator that many economists review is the Core CPI; this sub-index measures CPI leaving out the two most volatile components, food and energy. This allows economists to truly understand if goods and services which have steady rises in price are starting to accelerate faster than the average rate.

    1. it is easy to calculate and interpret.
    2. it is measured consistently from period to period and therefore allows for comparison over time.
    3. It is measured (more-or-less) objectively.

    1. It is based on a single basket of goods, which is an appropriate basis- more-or-less- for some individuals, but not necessarily all individuals.
    2. It doesn't consider changes in quality.
    3. It doesn't account for the substitution effect.
    4. The basket is updated infrequently. Thus, the "appropriateness" of the basket erodes over time until it is updated.
    Just as subatomic particles are the basic building blocks of physics, so prices and quantities are the fundamental building blocks of the economy, the foundation on which all analysis, theory, measurement, and policy rests. If prices or their rate of change, inflation, are not measured accurately, there will be cracks in the foundation. We will be prisoners of faulty statistics.
    But measuring inflation accurately is central to almost every economic issue, from monetary policy to measuring economic progress to the cost and structure of indexed spending and taxes. Many private contracts, including the forthcoming indexed Treasury bonds, are explicitly tied to the consumer price index (CPI), and an even larger number calibrate informally. Financial markets price expected future inflation into asset prices. About one-third of federal budget outlays are annually automatically escalated by the change in the CPI, as are income tax brackets (but unfortunately not the definition of income).
    Last winter, the Congressional Advisory Commission on the Consumer Price Index, which I chair, released its final report. My four eminent economist colleagues and I concluded that changes in the CPI currently overstate the change in the cost of living by about 1.1 percentage points a year. That is, if inflation as measured by the percentage change in the CPI is running 3 percent, the true change in the cost of living is about 2 percent. This bias might seem small. But when compounded over time, the implications are enormous. For example, over a dozen years, the cumulative additional national debt from over indexing the budget would amount to $1 trillion! Just the additional over indexing would be the fourth-largest program in the federal budget, after only Social Security, health care, and defense.
    The implications of overstating inflation for understanding economic progress are equally striking. Instead of falling by 13 percent, real hourly earnings have risen by 13 percent from 1973 to 1995. Certainly there has been a slowdown in wage growth, reflecting the productivity slowdown, but not a decline. Real median family income over the same period grew 36 percent, not the puny 4 percent in the official statistics that deflate by the CPI. The CPI component price indexes are also used as input into the national income accounts (NIA). Although the Commerce Department's NIA methodology reduces the bias from the CPI, much remains, and thus our measures of real economic growth and productivity gains are also understated substantially, by perhaps three-quarters of a percentage point a year.
    The commission recommended that the president and Congress explicitly decide whether they wish to continue the widespread substantial over indexing in the budget. If the purpose of indexing is a full and accurate insulation from changes in the cost of living, no more and no less, they should pass legislation wholly or partly correcting the problem. We describe several options in the report for doing so.
    The Fixed Basket
    But why does the CPI overstate actual inflation? The strength of the CPI is the underlying simplicity of its concept: pricing a fixed, but representative, market basket of goods and services over time. Its weakness follows from the same conception: the fixed basket becomes less and less representative over time as consumers respond to price changes and new choices.
    Follow the actual behavior of consumers in the economy. Hop into your car and drive to a discount outlet, purchase a VCR for your child's birthday; swing by the supermarket, where the price of beef has gone up substantially, so you buy chicken instead. Return home, defrost the frozen vegetables in the microwave oven, and turn on the television to watch the evening news. In this hour or two that reflects the everyday buying habits of millions of Americans, note the following: you drove on radial tires, which are far safer than bias-ply tires (and which last three to five times longer, thus reducing maintenance costs); the VCR you purchased for $170, which would cost $200 at a local appliance store, has many more features and is far more reliable than the first generation, which cost about $1,000 two decades ago; by substituting chicken, you ...

    Solution Summary

    Consumer Price Index calculation is achieved.