Académique Documents
Professionnel Documents
Culture Documents
2
Problems with CPI
CPI measures how much a persons income must change to maintain a
constant standard of living as measured by a standard (fixed) basket of
goods and services.
Problem 1: Substitution Bias
higher prices mean buy less of those goods.
Problem 2: Introduction of New Goods
greater variety not reflected in fixed basket.
Problem 3: Unmeasured Quality Change
quality improves with price unchanged.
3
Inflation and Interest Rates
Two Interest Rates
Nominal Interest Rate, i: return in current dollars.
Real Interest Rate, r: increase in purchasing power.
Relationship:
Expected Real Interest Rate
= Nominal Interest Rate Expected Inflation Rate
rE = i - p E
Where expected inflation rate is the average expected inflation rate through the maturity date
of the loan.