The consumer price Index (CPI) is one of the most important measuresused in economic analysis. It is basically used to monitor changes inthe cost of living over a given period of time. It is also one of thekey performance indicators of an economy hence the index is veryimportant and applicable in many levels such as setting of wages,rents, social security payments and other welfare programs (Hall &Lieberman, 2012). In some other cases, the index can be used bybusinesses in setting prices for products and services in a givenmarket. This paper thus expounds on the CPI as an importantmathematical computation used by economists to assess the performanceof an economy and also details how it is calculated.
The CPI measures changes in the cost of a representative basket ofgoods and services consumed by a typical consumer within a specifiedperiod of time. The CPI is not a dollar value but a measure of changeover time relative to a base period (1982-84) value of 100.00. Thechoice of base year may vary from one country to the other. Forinstance, India recently changed its base year from 2010 to 2012(Hall & Lieberman, 2012). In most cases, the period ofconsumption considered is one month, which is also used by the Bureauof Labor Statistics (BLS), a division of the Department of Labor.Thus each month, the BLS calculates the CPI and releases a report onthe same. Annual changes in CPI can be obtained by calculate annualaverage over the years. Ideally, it must be noted that the componentsof regular basket of consumer goods for a typical consumer may varyfrom one country to the other same as amounts. Most developedcountries are likely to consider a basket of goods with wider varietyand high quantities compared to developing and underdevelopedcountries.
National bodies mandated with calculating and releasing reports onCPI are responsible for determining the components of a basket ofgoods. This is accomplished by conducting national surveys calledFamily Budget Survey targeting several households to understand theirconsumption patters. The surveys are usually conducted after adefined period of time and are guided by a systematic internationalstandard method. In the US, the data is collected monthly from 6,000different households and 24,000 retailers across 87 urban centers inthe country (BLS 2015a). Durables and owner-occupied housing take aslightly different approach. The National consumer price approach fordurables attributes expenditure to the period of purchase though useextends beyond that period. For housing, the CPI approach assessesthe cost of using the services of the durable good as rentalequivalent (Diewert, Greenlees, & Hulten, 2010).
Again, the BLS has developed two types of CPI’s to correspond withdifferent sections of the population. The first one, CPIfor Urban Wage Earners and Clerical Workers (CPI-W), covershouseholds of wage earners and clerical workers (28% of nationalpopulation). The second one is CPI for All Urban Consumers (CPI-U)and the Chained CPI for All Urban Consumers (C-CPI-U), which coversapproximately 89 percent of the total population and includestemporary, technical, managerial and professional works,self-employed, retires and the unemployed and others not activelyengaged in the labor force (BLS 2015a).
To calculate the CPI, there are five important steps andconsiderations
Fix the basket and the weights
As earlier stated, the contents of a basket of goods that consumersconsume on a day-to-day basis changes with different factorsincluding region, age, market, and profession among others. Thus, tocalculate the CPI, the first step is determining what to include inthe basket and the weight attached to each. Goods and services thatare consumed in higher quantities are accorded more weight (BLS2015a). For instance, if a consumer takes more coffee cups perday than doughnuts, then coffee is accorded more weight.
Calculation of the CPI relies on the prices of thousands of goods andservices used by consumers. These prices are subject to inflationarypressures in the economy that can be caused by numerous factors. Infact, the general increase in prices in an economy which is regardedas inflation is actually a symptom of inflation. According to one ofthe renowned economics scholars, Gregory Mankiw (2011), inflationactually is an increases in the amount of money in an economic systemchasing a fewer goods and services. Thus, retailers tend to increaseprices in order to absorb the excess money in circulation in theeconomy and in the hands of buyers.
However, price isnot the only important thing in considering the basket to goods.
Compute the basket’s cost
Using data collectedon the cost of goods and services, the total cost of each basket atdifferent times is calculated. For purposes of consistency, thequality of goods and services within a single period of time (a monthin the US) is kept the same so as to capture only changes in costs ofthe basket and not the contents.
Choose a base year
A base year is anindex reference period. It is a designated base year used as abenchmark against which other years are compared.
Computation of the inflation rate
The change in CPI isused to compute inflation rate which is one of the major uses of CPI.The inflation rate is the percentage change in the price index fromthe preceding period. For instance, to calculate the inflation ratebetween year 2013 and 2014, the formula would be as below:
Uses of the CPI
Given that the CPIis used to measure inflation rate, it can be viewed as an indicatorof the effectiveness of the government’s economic policy andeconomic health status. Thus the CPI is used to inform government’seconomic decisions and fiscal and monetary policy (BLS, 2015b).
Deflator of other economic series
The CPI is sued todeflate other economic series. This means that the inflation rate isused to adjust other economic data info inflation free-dollars. Forinstance, interest rates accrued from savings can be adjusted intoinflation-free interest using the CPI. Earnings, sales and evennational income are adjusted for inflation. When national grossincome is adjusted inflation, it is thus termed as real income (BLS,2015b).
Means of adjusting dollar values
The CPI inflationrate is employed to adjust income payments. For instance, thegovernment can use the index to adjust social security payments. Inso doing, the payments are increased upwards if the inflation rate ispositive to ensure that they can afford their basket of good ordownwards if the inflation rate is negative. In other cases, unionagreements that tie wages to the CPI use this value to bargain forwage adjustments. In essence, high CPI inflation rate makesindividuals poorer as their fixed dollar values can afford a smallerbasket of goods (BLS, 2015b).
Problemsassociated with using CPI
Although the CPI is convenient in providing relative price ofcommodities across time, it does not provide an accurate cost ofliving. This is because of three main issues.
Substitution bias. Changes in prices of goods and services can result in consumers cutting the quality consumed or opting to consume cheaper substitutes. For instance, an increase in the price of Apple smartphone may mean that the consumer opts to consume a cheaper alternative. Thus the CPI does not reflect consumer preferences and substitution bias.
Introduction of new items. The CPI computation relies on a fixed basket of good. This basket does not consider introduction of new items. New items are thus ignored in the total cost computation and their substitution effect another goods is not recorded.
The CPI does not capture changes in quality of goods that may affect the composition of the goods basket or even the price. For instance, adjustment in quality of yoghurt consumed in a given period leads to improvement to improved standard of living but the cost of living shown by the price does not change.
Failure to predict economic cycles. Touryalai (2013) writing for Forbes notes that the CPI failed in predicting the 2008 financial crisis in the US precipitated by the housing bubble. Due to lower interest rates, the cost of housing, which is a major component of the fixed basket of goods, keeps going down. Lower CPI thus encourages lower interest rates thus leading to a negative feedback loop, between the Fed’s policies and CPI.
From the discussion above, it is clear that he CP is an importantindex in economics. It provides an important indication on the healthof the economy, the changes in prices and inflation. Based on thisindex, numerous economic policies are formulated. Nonetheless,certain weaknesses of the index have been noted. Until the currentapproach to CPI or an alternative index is formulated, the CPIremains to be for one of the most important indexes in managingeconomies.
BLS (2015a). Mathcalculations to better utilize CPI data. Retrieved from
BLS (2015b) How isthe Consumer Price Index (CPI) used? Retrieved from
Diewert, W.,Greenlees, J., & Hulten, C. (2010). Price index concepts andmeasurement.
Chicago: Universityof Chicago Press.
Mankiw, G. (2012).Principles of economics. New York: Cengage Learning.
Touryalai, H. (Jun24 2013). The major problem with CPI and how it hurts the economy.
Forbes Magazine. Retrieved fromhttp://www.forbes.com/sites/halahtouryalai/2013/06/24/the-major-problem-with-cpi-and-how-it-hurts-the-economy/
Hall, R. &Lierberman, M. (2012). Economics: principles and applications.New York: Cengage