Consumer Price Index

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ConsumerPrice Index

ConsumerPrice Index

Consumerprice index refers to a “measure of the average change over time inthe prices of consumer goods and services that people buy for day today living”. Consumer price index measurement is complex since ituses a combination of statistical techniques and skills in thesampling, collection and use of data as well as a wide range ofeconomic theories (International Labour Office, 2004). Therefore,calculation of consumer price index involves the services ofstatisticians, economists, data collectors and information technologyexperts. Additionally, consumer price index surveys and calculationsare dependent on voluntary supply of data from the general publicwithout compulsion or compensation from the government. The Bureau ofLabor Statistic publish consumer price index data every month, whichincludes the consumer price index for urban consumers (CPI-U),consumer price index for “urban wage earners and clerical workers”(CPI-W), and chained consumer price index for all urban consumers(C-CPI-U) (International Labour Office, 2004).

Themain rationale of consumer price index is to measure how a targetedgroup experience changed in prices of commodities and services. Thetwo main target populations are thus the “all urban consumers”and “urban wage earners and clerical workers”. Many of householdsin the United States fall under the “all urban consumers” whichconsists of all households except rural households, farm householdsand institutional households. Additionally, households classified as“urban wage earners and clerical workers” are also a subset ofthe “all urban consumers”. This population includes householdswhose fifty percent or more of their income originate from wages andsalaries or clerical work payments. However, this does not includesalaried professional, self employed individuals, part time workersor the unemployed (Mankiw, 2014).

Insimple terms, consumer price index provides an estimate of thechanges in price in a given period of time. The changes in consumerprice index is based on the weighted average of the changes in pricesof items sampled, which includes basic commodities and services suchas food, shelter, clothing and health care. The price ratio of thesampled item is a comparison between the previous and current priceof the item. The items weight represents the share of the totalconsumer spending. The formula used to determine these averageweights is called the index number formula. The cost of living indexhas also been developed to address underlying issues that have beenraised in the calculation of consumer price index (InternationalLabour Office, 2004). This cost is a hypothetical cost that isrequired to achieve particular living standards within a particularperiod of time. The ratio of the hypothetical cost and the real costin the consumption period gives the cost of living index. However,due to the fact that it is not possible to observe the cost ofachieving a particular living standard, the index is largely anapproximation. Despite this, it provides a measure of objectivenessand eliminates the bias in consumer price index measures.Additionally, consumer price index uses the Laspeyres formula toapproximate the measurement objectives. The formula provides the‘upper bound’ on the cost of living index and an average changesin prices across categories of items (International Labour Office,2004).

Itis also important to note that the standard of living is influencedby factors that are not captured in the traditional calculations ofconsumer price index. These are non price factors that have a cost ofconsumer goods. The objective nature of consumer price index may notprovide adequate approximation or consideration of these factors.These factors may include weather conditions, crime rates and healthproblems, free goods, environmental factors and goods and servicesprovided by the government at no cost. It is also important to notethat the scope of consumer price index covers consumer goods andservices only. This means that costs such as investments, lifeinsurance, gambling, gifts, and fines, donations to charity andillegal goods and services are outside the scope. Although consumerprice index covers changes in sales and related taxes, it is notaffected by before tax income. Changes in fees paid to government orgovernment institutions for provision of goods or services areconsidered to be a change in price in the calculation of consumerprice index. Additionally, government subsidies are also factored inthe consumer price index calculations. For example, if the governmenta subsidy lowers commuting cost, this is captured as a decrease inprice (International Labour Office, 2004).

Theindex value for the month represents the average changes in consumercommodity and services prices since the base period. In the UnitedStates, the base period is 1982-1983. Therefore, if the index is233.596 in July 2013, it can be interpreted that the prices of a setof consumer commodities that cost 100 dollars in the base period cost233 dollars in July 2013. However, since the base period is aboutthree decades ago, this interpretation do not make a lot of sense.Therefore, a comparison between the consumer price index for thecurrent month and the previous month or same month the previous yearmakes more economic sense. Therefore, a percentage change in consumerprice index is a common economic indicator. Another importantindicator derived from the consumer price index is specialaggregations which refer to indexes for a specific item such asenergy (Mankiw, 2014).

There are several uses of consumer price index. Consumer price indexis one of the most important and commonly used economic indicators inthe modern economic studies. It is an important measure of theeffectiveness and appropriateness of economic policies adopted bygovernment. Additionally, it is a major indicator of householdinflation and retail inflation in the economy. In the United States,the government, through the President, Congress and various boardsuses the changes in the consumer price index to monitor and formulateeconomic and fiscal policies. Although there are other economicindicators, consumer price index is one of the most important toolsused by government systems. For example, consumer price index can beused as an economic indicator to adjust or revise income taxblankets. This can be an economic and fiscal policy aimed atcontrolling particular types of inflation in the economy. Additionally, consumer price index is very valuable to the businessworld. Business enterprises, investors, labor movements and otherinstitutions makes economic decisions based on consumer price indexas an economic indicator (Mankiw, 2014).

Consumerprice index is also widely used in the determination and adjustmentof income payment levels. Consumer price index is a reflection ofabout 80 million Americans. Therefore, determination of competitiveremuneration in the public and private sector is largely influencedby consumer price index. Consumer price index is also an importantreference in collective bargaining agreements between employers andlabor movements. Alimony, child support and rents are also adjustedbased on published consumer price index. Consumer price index is alsoused as a deflector for other economic indicators and series. Some ofthe components of consumer price index are used in some statisticalprograms that are used in adjustment of prices and inflation values.For example, gross domestic product and retail sale measures seriesuse consumer price index or its components (Sexton, 2015).

Despitebeing a critical economic and fiscal tool, consumer price index hassome limitation. One of the main limitations of consumer price indexis the fact that it does not include commodities in the market thatare not purchased. Consumer price index covers commodities purchasedby urban consumers, which are bought in relatively low fraction whencompared to commodities supplied to the market. While representingthe composite consumer experience, consumer price index does not givean accurate indication of the price change experience on specifichousehold or individual. This means that it does not answer allquestions related to price movements in all populations(International Labour Office, 2004). It has also been argued thatconsumer price index does not determine the relative cost of livingin different geographical areas. For example, there are no indicatorsof differences in price level when geographical areas are considered.The consumer price index shows the degree to which prices in a givenarea changed, but does not compare different geographical regions.Another important limitation is the statistical error that isassociated with sampling. Consumer price index is estimated from asample of commodity purchase by consumers. Therefore, although itgives a relatively fair estimation, it is does not give the actualprice change measure. This means that if all the commoditytransactions were obtained, there is no doubt that the values wouldbe different (International Labour Office, 2004).

References

InternationalLabour Office (2004). Consumerprice index manual: theory and practice,Geneva: Internat. Labour Off.

Mankiw,N. (2014). BriefPrinciples of Macroeconomics.Cengage Learning, ISBN 1305161696.

Sexton,R. (2015). ExploringMacroeconomics.Cengage Learning, ISBN 1305465601.