Suppose that average consumption baskets bundles for Year 1

Suppose that average consumption baskets (bundles) for Year 1 and Year 2 are as shown in the table below: Pizza Slices Bottles of Beer Year 1 (quantity, price) {10 bottles, $2/bottle) 120 slices, $3/slice) Year 2 (quantity, price) {8 bottles, $4/bottle) {30 slices, $2/slice) (a) What is the percentage change in the price of each good? Calculate the consumer price index (CPI) for Years 1 and 2 using Year 1 as the base year. What is the inflation rate in the CPI? (b) Would all consumers be affected equally by the change in the cost of living as calculated using the CPI? Explain. (c) What does the change in quantities in Year 2 tell you about whether the CPI might overstate or understate the effect of price changes on the \"cost of living\"?

Solution

(a) In year 1 the sum of the price of the two goods is $5 (i.e.2+3)

    In year 2 the sum of the price of the two goods is $6 (i.e.4+2)

Then CPI = 6/5* 100 = 120

This means prices increased by 20% from year 1 to year 2.

It meanf inflation rate if 20%.

(b) The cost of living of all consumers increases, because value of money decreases.

(c) CPI understates the understate the effect of price change on cost of living. because it decreases the purchasing power of the consumer.

Total Expenditure in year 1 = (10 X $2) + (20 X $3) = $80

     Total Expenditure in year 2 = (8 X $4) + (30 X $2) = $92