What is the Consumer Price Index?

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The CPI of the current year is compared with that of the base year, which is considered 100. The CPI for the current year is either more or less than 100, with the former indicating an increase in the prices of the goods and services and the latter signifying the decrease in the costs over a period.

Key Takeaways

  • CPI measures the price fluctuation as indicated by the change in the prices of the goods and services in the market basket, which represents the most-used household items in an economy.The U.S. Bureau of Labor Statistics (BLS) has set the cost of the market basket for a base year at 100.The CPI assesses the level of inflation, deflation, and the purchasing power of an economy’s currency.As a significant economic indicator, CPI helps policymakers make informed financial decisions.

Consumer Price Index (CPI) Explained

Consumer Price Index (CPI) helps assess the inflation or deflation of an economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. The price fluctuations indicate how the cost of living would be affected. Plus, it also assesses the purchasing power of a nation’s currency.

The CPI is calculated based on the changes in the price of the goods and services in the market basket. This market basket, as mentioned above, contains a set of goods and services that are widely used by a population. However, the items included in these baskets vary based on the consumption habits of the nationals.  

It is used as an economic indicatorEconomic IndicatorSome economic indicators are GDP, Exchange Rate Stability, Risk Premiums, Crude Oil Prices etc. read more that acts as a proxy for the government’s policies, intending to keep inflation low to improve purchasing power. The changes in the CPI guide the government and policymakers to make suitable decisions for the benefit of the economy.

Consumer Price Index Formula

The CPI is calculated as the change in the prices of the products and services in the market basket for a period with respect to the same for the base year. The U.S. Bureau of Labor Statistics (BLS) has set the base year CPI to 100 during 1982-84.

The Consumer Price Index formula used for calculating the price fluctuation of the market basket’s items is:

Examples

Let us consider the following Consumer Price Index examples to understand things better:

Example #1 – (Manual Calculation)

The market basket for the year 2021 reflects the price change in the products and services with respect to that for the base year 2012. The details are as follows:

Example #2 – (Excel Format)

A country had four items on its CPI index- food, clothes, education, and fuel. A country has 2000 as the base year for measuring the CPI. In the year 2005, the government wanted to see if the purchasing power of the people of the country had improved or deteriorated. The price of each item is as below: –

Now, calculating the market basket for each year and then calculating the CPI we may get,

Market Basket Base year – 2000

Market Basket Current given year – 2005

Consumer Price Index Table

CPI = 101.18

Uses

Let us have a look at the list of uses to understand the Consumer Price Index definition in a better and easier way:

  • As an indicator of the economy, it helps policymakers to make informed decisions.CPI assesses consumers’ purchasing power. The increase in prices reduces the purchasing power of the customers and vice-versa.The price index acts as an adjusting factor, which authorities consider to determine the change in the wages or decide the minimum wage levels.It is used as an index to check the government’s social schemes and adjust the people’s living costs accordingly.Assessing the CPI can also help in adjusting other economic indicators accordingly. For example, adjusting the monthly/annual income of an employee.

Criticisms

CPI is one of the most important factors to assess the level of inflation occurring or expected to occur in the coming year. Thus, accuracy matters a lot. However, while calculating the CPI, the price changes for the current year are gathered based on random sampling. It means the samples collected and the price information collected may not necessarily be accurate. For example, the data collected might be more for a certain market or population than the other. As a result, the computation is likely to be influenced by the population figures, the amount of data from which is more. 

Therefore, the collection of the correct price data must be ensured to guarantee the proper calculation of the CPI.

This article is a guide to what is Consumer Price Index, its definition & formula. Here we explain how CPI & inflation are related along with calculation examples. You can learn more about economics from the following articles: –

CPI refers to the index that reflects the fluctuation in commodities’ prices with respect to the goods and services in the market basket. This basket represents the items most widely consumed by the households of an economy. The CPI is used to indicate the level of inflation or deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more in a nation and the purchasing power of a country’s currency.

CPI is calculated as the fluctuation in the market basket price for the current year compared to that of the base year. The CPI formula is expressed as:

CPI is an economic indicator knowing the value of which helps financial analysts assess the level of inflation or deflation in a country. In addition, the CPI also lets policymakers decide on the wages and minimum wage levels that workers and staff must receive to meet their lifestyle requirements. In short, CPI helps control the financial turmoil by implementing effective measures.

  • DuopolyDuopolyWhen there are two market leaders in any industry or service, this is referred to as a duopoly. Such companies have complete control of the market, earning high profits and gains in a specific sector or service. In the credit card industry, for example, Visa and MasterCard have a duopoly.read moreHerfindahl-Hirschman IndexHerfindahl-Hirschman IndexHerfindahl-Hirschman Index or HHI score refers to a measure of market concentration and indicates the amount of competition in a particular industry. read moreWhat is Paasche Index?What Is Paasche Index?Paasche Price Index is defined as a methodology to calculate inflation by measuring the price change in a commodity compared to the base year.read moreINDEX FormulaINDEX FormulaThe INDEX function in Excel helps extract the value of a cell, which is within a specified array (range) and, at the intersection of the stated row and column numbers.read moreCPI vs RPI