Question

(a) For each city across Canada, economists construct a price index for a similar basket of goods. In Edmonton (AB) the index is 132.00, and in Thunder Bay (ON) the index is 122.40. If you have been offered $130,000 for a job in Edmonton and $105,000 for a similar job in Thunder Bay, which job offers you the highest purchasing power for the bundle of goods in the price index? Use the Edmonton value as the base.        

(b) Evaluate the following statement: Using the CPI to compensate workers for inflation is appropriate because, in the face of a change in relative prices, people should be allowed to purchase the same bundle as they did before the price changes

Answer 1

(a)

Equivalent real income in Thunder Bay = Salary in Thunder Bay x (CPI in Edmonton / CPI in Thunder Bay)

= $105,000 x (132 / 122.4)

= $113,235.29

Since salary offered in Edmonton is higher ($130,000 / $113,235.29), Edmonton job gives higher purchasing power.

(b)

The statement is correct.

The higher the CPI, the higher the inflation rate since inflation is measured by the percentage change in CPI. Since inflation erodes purchasing power of money, higher inflation reduces real value of income. Therefore indexing nominal salary or income with CPI will make the income inflation-adjusted and will retain the same purchasing power.