Macroeconomics Essay Example
How representative the market basket used to measure CPI is and how to use the CPI in measuring inflation rate
The market basket used to measure CPI is representative to a large extent. This is because it comprises of items that are typically acquired by Australian households and although it does not include every item bought by households, it does include all the important kinds of items. The reason why all items are not included is because many related items are subject to similar price changes. Thus, the items selected are representative items with the index reflecting price changes for a much wider range of good and services than those used in the index (Imu.edu, 2016). The CPI is constructed such that all major commodity groups, subgroups and expenditure classes are included covering such items as alcohol, food, tobacco, footwear and clothing, housing and household contents and services, transport and communication, health, education, financial and insurance services as well as recreation. Depending on how important an item is, indexes are assigned to the subgroups in computing the CPI. A look at the subgroups will reveal that they include each and every product or service used by everyone everywhere in Australia in their day today lives. It would thus be right to conclude that the market basket used in computing the CPI is largely representative.
Despite the above argument, it is important to note that market basket used in computing the CPI has some weaknesses that limit its representativeness. For instance, the basket fails to factor in substitution. This is because when certain goods in the basket become significantly more expensive, consumers find less expensive substitutes (Mankiw, 2011). This consumer behavior is not reflected in the CPI basket but assumes that consumers continue buying the same amounts of the more expensive goods. The basket also fails to represent the ever increasing new products given the innovative nature of the market. CPI fails to include new goods until they become virtually staple consumer purchases. As such, though such goods may be a significant part of a consumer’s expenditure, they may not be represented in the basket for a long time. The CPI also fails to represent rural consumption given that it is constructed with a focus on metropolitan buying behaviors while failing to provide separate reports based on consumption by different consumer demographics (McGinty, 2015). Its representativeness is also questioned for its failure to factor in changes in quality of goods. This is because a change in price may be as a result of the net benefit a consumer enjoys from quality improvement thus, an increase in CPI does not appreciate additional benefits to consumers. Thus, while the CPI basket is largely representative as discussed above, its representativeness is brought to question owing to the representation flaws discussed above.
How CPI is used to measure inflation
CPI and inflation are related in that CPI is a measure of the average change over time in the prices that the metropolitan consumers pay for a market basket of goods and services while inflation is the overall general increase in prices of goods and services for an entire economy. As such, CPI is commonly used in measuring inflation.
To measure inflation, we obtain CPI for the base year which is the earlier year and the CPI for the current year or the year for which inflation we want to measure. Note that it is the government that sets the base year although it is arbitrary. We get the difference between CPI in the current year and the CPI in the base year (McGinty, 2015). We then calculate the rate of inflation by dividing the difference calculated by the CPI of the base year and then multiplying this by 100 to get inflation rate in percentage.
Inflation = (Current inflation-Historical CPI)/Historical CPI)) 100
CPI current year =200
CPI Base year = 170
Inflation = (200-170)/170)) 100 = 17.65%
Why unemployment rate is not a good indicator of the true measure of unemployment in the economy
The current definition terms as unemployed a person who is not working more than one hour in the reference week, who actively is actively looking for work in the previous four weeks and who is available to start work in the reference week. However, the definition leaves a lot of people who should be classified as unemployed. This means that unemployment rate being based on the definition is not a good indicator of the true measure of unemployment in the economy. In other words, the unemployment rate may actually be overstated or understated owing to such unemployed people as discouraged workers, unreported legal or illegal employment and part-time workers (Garry and Slaus, I2010). Owing to the above groups not being factored in the unemployment rate, the true unemployment in the economy may be understated during periods of economic contraction and overstated during periods of economic expansion.
Factors such as discouraged workers and part-time workers are excluded in unemployment rate computation thus underestimating it. Discouraged workers are those willing and able to work and ready to accept work but due to unsuccessful attempts at finding jobs, they have given up actively seeking employment. These people have been placed in the not in the labor force category since to be considered unemployed, one must be actively seeking work. Thus, they are not included in the official unemployment rate computation despite the fact that discouraged workers actually are unemployed labor resources and hence should be included in the unemployment rate. If this is done, the unemployment rate would be boosted say from 5 to 5.5%. On the other hand, part-time workers are those able and willing to work for 35-40 hours a week (full time) but have to work less since their productive efforts are not needed by employers at certain times. When they have jobs, they are included in the employed category in calculating unemployment rate yet their labor resources are only partially employed. They should however be considered partially employed depending on the hours they work. As such, the part time employed ought to be included in the unemployment rate which would raise the rate from say 5-8%.
Other factors overestimate the unemployment rate. Such factors include unreported legal employment. This is because the government may not be able to know whether all people collecting unemployment benefits are actually unemployed. Some employed people fraudulently fail to inform government of their employment (Soergel, 2015). These people are included in the unemployment rate although they are actually employed thus overstating the rate. The same case applied to those engaged in illegal employment such as gambling, prostitution and such related illegal activities. These people cannot report their employment status to the government and hence they may be included among the unemployed. Including them among the unemployed acts to decrease the unemployment rate below what it actually is.
The exclusion of the above elements that vary depending on the business cycle means that the actual unemployment rate is likely to fluctuate more during the business cycle as opposed to the officially reported unemployment rate. This means that the actual unemployment rate may be higher or lower than the reported unemployment rate depending on the phase of the business cycle. This is thus an indication that unemployment rate is not a good indicator of the true measure of unemployment in the economy.
Mankiw, G2011, Principles of macroeconomics, South Western Cengage Learning.
Imu.edu, 2016, Consumer price index (CPI), Retrieved on 20th September 2016, from;
McGinty, B2015, CPI vs. PCE: Untangling the alphabet soup of inflation gauges, Retrieved on 20th September 2016, from;
Garry, J&, Slaus, I2010, Indicators of economic progress: The power of measurement and human welfare, Retrieved on 20th September 2016, from;
Soergel, A2015, Unemployment indicators only tell part of the story, Retrieved on 20th September 2016, from;
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