Question

Suppose that King Julien of Lemurland asks you to construct a consumer price index. Based on your research you choose a market basket that contains 3,000 yams and 2000 coconuts. Suppose further that the prices of each good from 2014 – 2016 are as follows: Base year is 2014.

Year	Price of Yams	Price of Coconuts
2014	1.50	2.00
2015	1.75	2.20
2016	1.84	2.25

A. What is the CPI for each year?

B. Based on the data, what is the annual rate of inflation in 2015 and 2016 (use the initial value formula)

C. Give and briefly explain at least two reasons that the CPI, as calculated above, may tend to overstate the rate of inflation.

Answer 1

Assume Base year as 2014

Year	Price of yams	Price of coconuts	Cost of basket
2014	1.5	2	1.5x3000+2x2000 = 8500
2015	1.75	2.20	1.75x3000+2.20x2000 = 9650
2016	1.84	2.25	1.84x3000+2.25x2000 = 10020

A)CPI = 100 x ( COst of market/ cost of base price)

CPi 2014 = 100 x (8500/8500) = 100

CPI 2015 = 100 x (9650/8500) = 113.53

CPI 2016 = 100 x (10020/8500) = 117.89

B) Inflation =( [Inflation new value/ Inflation old value] - 1 ) x 100

Inflation 2015 = ( [113.53/100) -1 ] x 100 = 13.53%

inflation 2016 = ( [117.89/113.53] -1) x100 = 3.84%