The Consumer Price Index (CPI) is the most widely monitored and used measure of the inflation rate. It is also sometimes used to measure the efficacy of a country’s economic policy.
What is the Consumer Price Index (CPI)?
The CPI is an economic indicator that measures the average price change consumers pay for a fixed bundle of goods and services called a market basket.
In simple terms, the CPI is a price index measuring the value of a basket of goods a typical consumer buys. It can serve as a valuable indicator to determine the cost of living and the purchasing power of a nation's currency.
Most nations update their CPI monthly based on the pattern in which individuals (of all age groups) or households spend disposable income on goods and services.
The History of CPI
The foundation of the CPI can be traced back to the period after WWI when there was a sudden rise in the prices of consumer goods and services and the cost of living. A deterioration in wages forced the workers to demand compensation.
As a result, economic surveys among the working classes were conducted to measure the cost of living. Before July 1955, the CPI numbers were known as “Cost of Living Index Numbers”.
Later, the Sixth International Conference of Labor Statisticians (ICLS) suggested changing the vocabulary from the Cost of Living Index to the Consumer Price Index.
Most CPI index series use 1982-84 as the reference period for comparison. This period was chosen to match the updated household expenditures on consumer goods and services, based on the Consumer Expenditure Surveys of 1982, 1983, and 1984.
The U.S. Bureau of Labor Statistics (BLS) set the index level during the 1982-84 period at 100. A deviation from this value (CPI of 100) would indicate a change in the price of the market basket. For example, an index of 110 indicates a 10% rise in the market basket price compared to the reference period. Similarly, a CPI of 90 indicates a 10% decrease in the cost of the market basket.
What Is the Purpose of the Consumer Price Index?
The CPI is an important economic indicator for the following reasons:
In broad terms, a country’s CPI measures the price of commodities and how they are trending. It can determine the purchasing power of a nation’s currency. The CPI also serves as an indicator of the effectiveness of a nation’s economic policy.
The CPI is one of the most commonly used tools for measuring inflation and deflation. Inflation is a key indicator of a nation's economic health. Governments and economic agencies use CPI, among other indices, to make informed economic decisions.
Another use of the CPI is to adjust other economic indicators. For example, it can be used to adjust components of national income.
CPI also guides wage adjustments according to the cost of living. In the United States, roughly 70 million military veterans, retired government employees and workers, and social security beneficiaries have cost-of-living adjustments based on the CPI.
Furthermore, the CPI can determine whether someone is eligible for benefits such as social security.
Economists use data derived from the CPI to measure the real gross domestic product, the total value of goods and services an economy produces (minus inflation).
Who and What Does the Consumer Price Index Target?
The CPI targets the urban population and their spending habits.
The CPI mainly monitors eight categories of goods and services. These include housing, food and beverages, transportation, apparel, medical care, education, recreation, communication, and other goods and services.
An important point is that the CPI does not consider non-tangible offerings on which consumers spend money, such as insurance and investments.
What is the Consumer Price Index formula? How do I calculate the CPI?
According to the U.S. Bureau of Labor Statistics (BLS), the Consumer Price Index formula is:
CPI = Price of the market basket in a year / Price in the base year * 100.
A market basket is a fixed bundle of goods and services. So, to calculate the CPI, we need to know the total amount of money consumers spend on a fixed bunder of goods and services. This means that the CPI is calculated in comparison to a base year.
Example: Person A spent $200 on consumer goods and services in 2018 and $300 on the same goods in 2023. What will the CPI of person A be in 2023?
According to the consumer price index definition, Person A spent $200 on all consumer goods and services (market basket) that he bought in 2018 (base year) while spending $300 in 2023 for the same market basket.
Then, CPI = (300/200) *100 = 150
What are the types of Consumer Price Indexes?
There are two types of CPI in the United States, and the separation is based on two population groups. They are:
- Primary CPI: CPI for All Urban Consumers (CPI-U)
- Secondary CPI: CPI for Urban Wage Earners and Clerical Workers (CPI-W)
The only differentiating factor between these two indices is population coverage.
Consumer Price Index vs Inflation Rate vs Cost of Living Index: What’s the Difference?
Consumer Price Index: The CPI is a tool used to measure inflation. Based on the total price of the market basket, an accurate estimate of the cost of living Can be made.
Inflation Rate: The inflation rate is the rate at which prices increase over time, resulting in the decline of the purchasing power of a nation’s currency.
Cost of Living Index: The Cost of Living Index is a price index used to track how much the cost of basic expenses (food, shelter, transportation, energy, healthcare, education, entertainment, etc) rises over time.
What are the Advantages and Disadvantages of the CPI Index?
Advantages of the Consumer Price Index
- It measures and tracks the rate of inflation and the cost of living
- It offers information on previous prices. This is valuable data that experts use to determine the price change over time
- It is an important means of adjusting dollar values and wages
- It is used to find the real wage, which is an indicator of the purchasing value of an increased wage
- CPI is consistent as it measures a fixed set of goods irrespective of how goods and services evolve.
- It directly influences a country’s economy; governments use the CPI to make informed economic decisions.
Disadvantages of the Consumer Price Index
- It does not represent all the consumption within an economy. It considers only selected goods and services that make up the market basket.
- It does not factor in substituting products or services that consumers deem expensive.
- The CPI market basket only includes staple items and does not include novel goods.
- Its accuracy is questionable because many items are not taken into consideration.
- It only focuses on urban consumers and does not provide a separate report of different demographic groups.
- It does not factor in the quality of goods or services.
Conclusion
The Consumer Price Index (CPI) remains one of the most important price indices. Economists and national statistics agencies have closely followed it as it directly impacts a nation's economy. As a result, the CPI has been accepted as a valuable economic indicator in most countries as its many advantages outweigh its shortcomings.
Key Takeaways
- The Consumer Price Index is an index that measures the value of a basket of goods bought by a typical consumer.
- The CPI for the base year is set at 100.
- The CPI is a widely accepted indicator of inflation and deflation.
- CPI = Price of the market basket in a year / Price in the base year * 100.
- CPI, Cost of Living Index, and Inflation are closely related concepts; however, they are not the same.
FAQ
What goods and services are covered in the consumer price index?
The CPI covers eight major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services). It also includes certain government-charged user fees (e.g., water and sewage charges, auto registration fees, vehicle tolls, etc).
What is not included in the CPI?
CPI does not include non-tangible items consumers spend on, such as insurance and investments.
Is the CPI the same as inflation?
No, the CPI is not the same as inflation. The two terms are closely related as CPI measures the inflation rate.
Is the CPI the same as the Cost of Living Index?
The CPI is different from the Cost of Living Index because it does not include the standard of living related to working conditions, health, education, housing conditions, debt, savings, etc.
Is the CPI a good indicator of inflation?
The CPI is widely accepted as one of the best inflation indicators because it covers goods and services, while other indicators, like the Wholesale Price Index (WPI), cover only goods.
How do I get information on the CPI?
You can access data on CPI from the BLS website. You can get other information on CPI on the CPI home page.