Chapter 24 Journal

In this chapter, we encounter the concept of Consumer Price Index (CPI), which measures the cost of a basket of goods and services relative to the cost of that same, fixed basket of goods in a base year. This index is used to measure the overall level of prices in the economy, and the percentage change in the CPI also measures the inflation rate. The CPI is important in measuring the cost of living, but it is flawed in that it does not account for substitution bias, the introduction of new goods, and the unmeasured change in the quality of goods and services. Because of these issues, the CPI overstates inflation. The GDP deflator, which we learned about last chapter, is similar to the CPI in that it measure the overall level of prices in the economy, however it differs in that the CPI includes goods produced internationally, and the CPI uses a fixed basket of goods as well as a changing one. Additionally, dollar figures are not representative of a valid comparison of purchasing power because of changing interest rates and inflation. You can correct this by using a price index. Laws and contracts also use price indexes to correct for inflation, and tax laws are partially indexed for inflation. Correction for inflation is especially important when considering interest rates. The nominal interest rate is the one usually reported (rate at which the number of dollars increases over time). The real interest rate accounts for changes in the value of the dollar over time.