Find the prices the BLS collects data on the prices of all the goods in the

Find the prices the bls collects data on the prices

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Find the prices: the BLS collects data on the prices of all the goods in the basket 3. Compute the basket’s cost: use the prices to compute the total cost of the basket 4. Choose a base year and compute the index: CPI in any year=100xcost of basket in a current year/cost of basket in a base year 5. Compute the inflation rate: the percentage change in the CPI from the preceding period : Inflation rate=CPI this year-CPI last year/CPI last yearx100% What’s in a CPI’s basket? (Highest percentage to least) Housing (41%) Transportation (17%) Food and beverages (15%) Education and communication (7%) Medical care (7%) Recreation (6%) Apparel (4%) Other goods and services (3%)
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Problems with CPI: Substitution Bias Over time, some prices rise faster than others Consumers substitute towards goods that become relatively cheaper, mitigating the effects of price increases The CPI misses this substitution because it uses a fixed basket of goods with fixed weights Thus, the CPI overstates increases in the cost of living Problems with CPI: Introduction of new goods The intro of new goods increases variety, allows consumers to find products that more closely meet their needs In effect, dollars become more valuable The CPI misses this effect bc it uses a fixed basket of goods Thus, the CPI overstates increases in the cost of living Problems with CPI: Unmeasured Quality Change Improvement in the quality of goods in the basket increase the value of each dollar The BLS tries to account for quality changes but probably misses some, as quality is hard to measure Thus, the CPI overstates increases in the cost of living Problems with CPI: Each of these problems causes the CPI to overstate cost of living increases The BLS has made technical adjustments, but the CPI probably still overstates inflation by about .5% each year This is important because Social Security payments and many contracts have Cost Of Life Arrangements (COLA) tied to the CPI CPI measures housing costs from rents, not from housing prices, why this may be a problem? CPI vs. PCE (2 inflation gauges) Fed’s preferred measure of consumer-price growth is the PCE (Personal Consumption Expenditures) bc: 1. The PE includes a broader range of expenditures than CPI 2. It’s weighted according to data provided in business surveys, rather than the less reliable consumer surveys used to weigh the CPI 3. It uses a formula that adjusts for changes in consumer behavior that occur in the short term, something the standard CPI formula doesn’t do PCE, includes all goods and services consumed in the US whether they are purchased by consumers or by employers or federal programs on behalf of consumers Medical expenses provide a good example of the differences in approach: the CPI includes only the co-payments paid directly by consumers in its calculation, while the PCE captures co-payments as well as costs covered by employer-provided insurance and govt programs
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