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Consumer Price Index

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Consumer Price Index

If you're like most people, you probably find yourself wondering "why doesn't my money go as far as it used to?" In fact, it's very common to find yourself feeling like you aren't able to purchase as many "things" as you were once able to.

As it turns out, economists have done a lot of work to understand this phenomenon, and have developed models and concepts you might be very familiar with. For example, if you've ever heard of inflation or the Consumer Price Index (CPI), you've already been exposed to this idea.

Why is inflation such a pervasive subject, and why is it so important to measure? Continue reading to learn why!

Consumer Price Index meaning

You may already know that the Consumer Price Index (CPI) is a way to measure inflation, but what is inflation?

Ask the common person this question, and they'll all say basically the same thing: "it's when prices go up."

But, which prices?

In order to tackle the idea of how far someone's money goes, and how quickly prices are increasing, or decreasing, economists use the notion of "baskets." Now we're not talking about physical baskets, but rather hypothetical baskets of goods and services.

Since trying to measure the price of every good and every service available to all people across various segments, and at all times, is virtually impossible, economists decided to identify a representative "basket" of goods and services that many people generally purchase. This is how economists do the Consumer Price Index calculation so that it might be an effective indicator of how prices for ALL goods and services in that segment are changing over time.

Thus the "market basket" was born.

The market basket is a group, or bundle, of goods and services commonly purchased by a segment of the population that is used to track and measure changes in an economy's price level, and the cost of living facing those segments.

Economists use the market basket to measure what is happening to prices. They do so by comparing the cost of the market basket in a given year to the cost of the market basket in the base year, or the year we're trying to compare changes to.

The Consumer Price Index in a given year is calculated by dividing the cost of the market basket in the year we want to understand, by the cost of the market basket in the base year, or the year that is chosen as the relative starting point.

Consumer Price Index calculation

Price indexes are used in a multitude of ways, but for the purposes of this explanation we will be focusing on the Consumer Price Index.

In the U.S., the Bureau of Labor Statistics (BLS) checks prices on 90,000 items at more than 23,000 urban retail and service outlets. Since prices for similar (or the same) goods can vary from region to region, much like gas prices, the BLS checks prices of the same items in various parts of the country.

The purpose of all this work by the BLS is to develop the generally accepted measure of the cost of living in the United States—the consumer price index (CPI). It's important to understand that the CPI measures the change in prices, not the price level itself. In other words, the CPI is strictly used as a relative measure.

The Consumer Price Index (CPI) is a measure of the relative change over time of prices experienced by urban households in an economy using a representative basket of goods and services.

Now while it seems self-evident that the CPI is an important measure of the change in prices facing household, or consumers, it also plays an important role in helping economists understand just how far a consumer's money goes.

Put another way, the consumer price index (CPI) is also used to measure the change in income a consumer would need to earn in order to maintain the same standard of living over time, given changing prices.

You might be wondering how exactly the CPI is calculated. Probably the easiest way to conceptualize it is through the use of a hypothetical numerical example. Table 1 below shows the prices of two items across three years, where the first one is our base year. We'll take these two items to be our representative basket of goods.

The CPI is calculated by dividing the cost of the total basket in one period by the cost of the same basket in the base period. Note that the CPI periods can be calculated for month-over-month changes, but most often it is measured in years.

(a) Base Period
Item
Price
Amount
Cost
Macaroni & Cheese
$3.00
4
$12.00
Orange Juice
$1.50
2
$3.00
Total Cost
$15.00
(b) Period 2
Item
Price
Amount
Cost
Macaroni & Cheese
$3.10
4
$12.40
Orange Juice
$1.65
2
$3.30
Total Cost
$15.70
(c) Period 3
Item
Price
Amount
Cost
Macaroni & Cheese
$3.25
4
$13.00
Orange Juice
$1.80
2
$3.60
Total Cost
$16.60

Table 1. Calculating the consumer price index - StudySmarter

You may be wondering if the work here is done...unfortunately not. You see, economists don't really care that the CPI was 104.7 in Period 2 and 110.7 in Period 3 because...well the price level doesn't really tell us much.

In fact, imagine there was an percentage change in overall wages that was equivalent to the changes captured in Table 1. Then, the actual impact would be zero in terms of purchasing power. Purchasing power is the most important aspect of this exercise - the distance a consumer's money goes, or how much a household can buy with their money.

That's why it's essential to keep in mind that it's the rate of change in the CPI that matters most. When we take this into account, we can now speak meaningfully about how far one's money goes by comparing the rate of change in earnings to the rate of change in prices.

Now that we have taken the time to understand the CPI, how to calculate it, and how to properly think about it, let's discuss how it's used in the real world and why it's such an important variable.

Importance of Consumer Price Index

The CPI helps us measure inflation between one year and the next.

The inflation rate is the percentage change in the price level over time, and is calculated as follows:

Thought of in this way, we can now say that, in our hypothetical example in Table 1, the inflation rate in Period 2 was 4.7% (104.7 ÷ 100). We can use this formula to find the inflation rate in Period 3:

Before we move on to the next important idea, it's important to note that prices don't always go up!

There have been instances where prices have actually decreased from one period to the next. Economists call this deflation.

Deflation is the speed, or percentage rate, at which the prices of the goods and services bought by households fall over time.

There have also been instances where prices continued to increase, but at a decreasing speed. This phenomenon is called Disinflation.

Disinflation occurs when there is inflation, but the rate at which the prices of goods and services are increasing is decreasing. Alternately put, the speed of price increases is slowing down.

Inflation, deflation, and disinflation can be triggered, or accelerated through Fiscal Policy or Monetary Policy.

For example, if the government felt that the economy wasn't performing at the level it should, it might increase its spending, leading to an increase in GDP, but also in aggregate demand. When this happens, and the government takes an action that shifts the aggregate demand to the right, equilibrium will only be achieved through increased output and increased prices, thereby creating inflation.

Similarly, if the central bank decided that it may be facing a period of unwanted inflation, it might raise the interest rates. This increase in interest rates would make loans for purchasing capital more expensive thereby depressing investment spending, and it would also make home mortgages more expensive which would slow consumer spending. In the end, this would shift aggregate demand to the left, decreasing output and prices, causing deflation.

Now that we have put the CPI to use in measuring inflation, we need to talk about why it's important to measure inflation.

We briefly mentioned why inflation is an important metric, but let's dive in a bit deeper to understand the very real impact inflation has to real people like you.

When we talk about inflation, it's not so important to just measure the rate of change of prices, as much as it is to measure how that rate of price change has affected our purchasing power--our ability to acquire goods and services that are important to us and maintain our standard of living.

For example, if the inflation rate is 10.7% this period relative to the base period, that means the price of the basket of consumer goods has increased by 10.7%. But how does that impact regular people?

Well, if the average person does not experience any change in wages during that same period, that means that every dollar they earn now goes 10.7% less far than it did in the base period. Put another way, if you make $100 a month (since you're a student), the products you used to buy for that $100 now cost you $110.70. You now have to make decisions as to what you can no longer afford to buy!

With a 10.7% inflation rate, you have to deal with a new set of opportunity costs that will mean foregoing certain goods and services, since your money won't go as far as it used to.

Now, 10.7% might not seem like that much, but what if an economist told you the the periods they were measuring weren't years, but rather months! What would happen in a year if the level of monthly inflation kept increasing at a rate of 5% per month?

If inflation was increasing the prices of the goods and services that households were purchasing by 5% per month, that would mean that in one year, the same bundle of goods that cost $100 in January of last year would cost almost $180 one year later. Can you see now how dramatic an impact that would have?

You see, when we talk about the representative basket of goods that households spend their money on, we're not talking about luxuries or discretionary items. We're talking about the cost of basic living needs: the price of keeping a roof over your head, the cost of gas to get to work or school and back, the cost of the food you need to keep you alive, and so on.

What would you give up if the $100 you now had could only buy you $56 worth of the things you could have purchased one year ago? Your home? Your car? Your food? Your clothes? These are very difficult decisions, and very stressful ones at that.

This is why many wage increases are designed to compensate for the inflation rate as measured by the CPI. In fact, there is a very common term for the upward adjustment to wages and earnings every year - the cost of living adjustment, or COLA.

The cost of living is the amount of money a household needs to spend in order to cover basic expenses such as housing, food, clothing, and transportation.

This is where we begin to think of the CPI and inflation rates not in terms of their nominal values, but in real terms.

Consumer Price Index and Real vs. Nominal Variables

What do we mean by real terms as opposed to nominal?

In economics, nominal values are the absolute, or actual numerical values of a variable in different periods. Real values adjust the nominal values for differences in the price level, or inflation. Put another way, the distinction between nominal and real measurements occurs when those measurement have been corrected for inflation. Real values capture actual changes in purchasing power.

For example, if you earned $100 last year and the inflation rate was 0%, then your nominal and real earnings were both $100. However, if you earned $100 again this year, but inflation has risen to 20% over the year, then your nominal earnings are still $100, but your real earnings are only $83. You only have the equivalent of $83 worth of purchasing power because of the rapid increases in prices. Let's look at how we calculated that result.

In order to convert a nominal value into its real value, you would need to divide the nominal value by the price level, or CPI, of that period relative to the base period, and then multiply by 100.

In the example above, we saw that your nominal earnings stayed at $100, but the inflation rate went up to 20%. If we take last year to be our base period, then the CPI for last year was 100. Since prices have gone up 20%, the CPI of the current period (this year) is 120. As a result, ($100 ÷ 120) x 100 = $83.

The exercise of converting nominal values into real values is a key concept, and an important conversion because it reflects how much money you actually have relative to rising prices--that is, how much purchasing power you actually have.

Let's consider another example. Let's say your earnings last year were $100, but this year, your benevolent boss decided to give you a cost of living adjustment of 20%, resulting in your current earnings being $120. Now assume that the CPI this year was 110, measured with last year as the base period. This, of course means that inflation over the last year was 10%, or 110 ÷ 100. But what does that mean in terms of your real earnings?

Well, since we know that your real earnings are simply your nominal earnings this period divided by the CPI for this period (using last year as the base period), your real earnings are now $109, or ($120 ÷ 110) x 100.

As you can see, your Purchasing Power has increased relative to last year. Hurray!

Purchasing power is how much a person or household has available to spend on goods and services, in real terms.

You might be wondering how inflation rates have actually changed over time in the real world. Hypothetical examples are fine when explaining an idea, but as we now know, sometimes these ideas have very real consequences.

Consumer Price Index chart

Are you curious as to what the CPI and inflation has looked like over time? If so, that's a good thing to wonder, and the answer is, it depends significantly on where you live. Not just which country, either. Inflation and the cost of living can vary widely within a country.

Consider the CPI growth in Brazil shown in Figure 1 below.

Consumer Price Index Brazil CPI StudySmarter OriginalsFigure 1. Brazil CPI, StudySmarter Originals.Aggregate growth shown here measures changes in annual total CPI with base year 1980.1

As you examine Figure 1, you might be wondering "what on earth happened in Brazil in the late 80's and 90's?" And you'd be quite right to ask that question. We won't get into the details here, but the reasons were primarily due to the Brazilian federal government's fiscal and monetary policies that generated inflation between 1986 and 1996.

In contrast, if you examine Figure 2 below, you can see how the price level in the U.S. compared to that of Hungary over time. Whereas the previous graph for Brazil showed changes in price level from year to year, for Hungary and U.S., we are looking at the price level itself, although both countries' CPI is indexed to 2015. Their price levels weren't actually similar in that year, but they both show a value of 100, since 2015 was the base year. This helps us to see a wider picture of the year-to-year changes in the price level in both countries.

Consumer Price Index CPI for Hungary vs USA StudySmarter OriginalsFigure 2. CPI for Hungary vs USA, StudySmarter Originals.CPI shown here includes all sectors. It is measured annually and indexed to base year 2015.1

In looking at Figure 2, you might notice that, while Hungary's CPI level was more modest in the 1980's in comparison to that of the United States, it was steeper between 1986 and 2013. This, of course, reflects higher annual inflation rates in Hungary during that time period.

Criticisms of the Consumer Price Index

When learning about the CPI, inflation, and real versus nominal values, you might have found yourself wondering "what if the market basket used to calculate CPI wasn't really reflective of the items I buy at all?"

As it turns out, many economists have asked that very same question.

Criticisms of the CPI are rooted in this idea. For example, it can be argued that households change the mix of goods and services they consumer over time, or even the goods themselves. You can imagine a scenario where, if the price of orange juice doubled this year due to a drought, you might just drink soda instead.

This phenomenon is called the substitution bias. In this scenario, can you say that the inflation rate you actually experienced was accurately measured by the CPI? Probably not. The items in the CPI are updated periodically to reflect changing tastes, but there is still a bias created by holding the basket of goods constant. This doesn't reflect the fact that consumers can change their basket of goods in response to these very prices.

Another criticism of the CPI is rooted in the notion of improvements in the quality of goods and services. For example, if the competitive landscape for orange juice was such that no one provider could increase prices due to perfect competition, but in order to capture more of the market they started using fresher, juicier, higher quality oranges to make their orange juice.

When this occurs, and it does occur, can you really say that you're consuming the same product that you were last year? Since the CPI only measures prices, it doesn't reflect the fact that the quality of some goods may improve dramatically over time.

Yet another criticism of the CPI, one that is similar to the quality argument, is about improvements in goods and services due to innovation. If you own a cell phone, it's likely that you've experienced this directly. Cell phones are continually improving in terms of functionality, speed, picture and video quality, and more, because of innovation. And yet, these innovative improvements see price decreases over time, due to fierce competition.

Once again, the good you purchased this year is not at all the same as the one you purchased last year. Not only is the quality better, but thanks to innovation, the product actually satisfies more needs and wants than it used to. Cell phones give us capabilities that we didn't have just a few years ago. Since it compares a constant basket from one year to the next, the CPI doesn't capture changes due to innovation.

Each of these factors cause the CPI to estimate an inflation level that somewhat overstates the true loss in well being. Even as prices rise, our standard of living is not staying constant; it is perhaps far outpacing the rate of inflation. Despite these criticisms, the CPI is still the most commonly used index for measuring inflation, and while it's not perfect, it's still a good indicator of how far your money goes over time.

Consumer Price Index - Key Takeaways

  • The market basket is a representative group, or bundle, of goods and services commonly purchased by a segment of the population; it is used to track and measure changes in an economy's price level, and the cost of living changes.
  • The Consumer Price Index (CPI) is a measure of prices. It is calculated by dividing the cost of the market basket, by the cost of the same market basket in the base year, or the year that is chosen as the relative starting point.
  • The inflation rate is the percentage increase in the price level over time; it is calculated as the percentage change in CPI. Deflation occurs when prices are falling. Disinflation occurs when prices are rising, but at a decreasing rate. Inflation, deflation, or disinflation can be triggered, or accelerated through fiscal and monetary policy.
  • Nominal values are absolute, or actual numerical values. Real values adjust nominal values for changes in the price level. Real values reflect changes in actual purchasing power--the ability to buy goods and services. The cost of living is the required amount of money a household needs in order to cover basic living expenses such as housing, food, clothing, and transportation.
  • Substitution bias, quality improvements, and innovation are some of the reasons why the CPI is thought to likely overstate inflation rates.

  1. Organization for Economic Co-operation and Development (OECD), https://data.oecd.org/ Retrieved May 8, 2022.

Frequently Asked Questions about Consumer Price Index

The Consumer Price Index (CPI) is a measure of the relative change over time of prices experienced by urban households in an economy using a representative basket of goods and services.

If the Market Basket is estimated to have increased in price this year over last year by 36%, it can be said that this years' CPI is 136.

The Consumer Price Index (CPI) is a measure of the relative change over time of prices experienced by urban households in an economy using a representative basket of goods and services.

The CPI is calculated by dividing the total cost of the market basket in one period by the market basket in a base period, multiplied by 100:

Total Cost Current Period ÷  Total Cost Base Period x 100.

The consumer price index is useful because it estimates inflation levels, and it can also be used to estimate real value such as real earnings.

Final Consumer Price Index Quiz

Question

The ______ ______ is a group, or bundle of goods and services commonly purchased by a segment of the population that is used to track and measure changes in an economy's price levels, and the cost of living facing those segments. 

Show answer

Answer

market basket

Show question

Question

The Consumer Price Index is calculated by dividing the cost of the market basket in the _______ year by the cost of the market basket in the ____ year.

Show answer

Answer

current, base

Show question

Question

The ____________ is a measure of the relative change over time of prices experienced by urban households in an economy using a representative basket of goods and services. 


Show answer

Answer

consumer price index, CPI

Show question

Question

The _________ ____ is the speed, or percentage rate, at which the prices of the goods and services bought by households rise over time.


Show answer

Answer

inflation rate

Show question

Question

The inflation rate is calculated by dividing the ________ by the ________ multiplied by 100.

Show answer

Answer

CPI current period, CPI base period

Show question

Question

_________ is the speed, or percentage rate, at which the prices of the goods and services bought by households fall over time. 

Show answer

Answer

Deflation

Show question

Question

___________ occurs when the speed of price increases is slowing down. 


Show answer

Answer

disinflation

Show question

Question

Inflation, deflation, and disinflation can be triggered, or accelerated through ______ ______ or ________ ______


Show answer

Answer

monetary policy, fiscal policy

Show question

Question

The ____ __ ______ is the amount of money a household needs in order to buy basic expenses such as housing, food, clothing, and transportation. 


Show answer

Answer

cost of living

Show question

Question

In economics, _______ values are the absolute, or actual numerical values of a variable in different periods. 


Show answer

Answer

nominal

Show question

Question

____ values reflect nominal values that have been adjusted for inflation.  


Show answer

Answer

real

Show question

Question

In order to convert a nominal value into its real value, you would need to divide the nominal value by the ___ of that period and multiply by 100. 


Show answer

Answer

CPI, consumer price index

Show question

Question

Money gives individuals and households _________ _____ , which is the ability to acquire goods and services. 

Show answer

Answer

purchasing power

Show question

Question

Which of the following is NOT a reason why the CPI might overstate inflation?

Show answer

Answer

Foreign investment

Show question

Question

If the CPI in a country was 128.3 in 1990 and 125.6 in 1991, what is the inflation rate in 1991?

Show answer

Answer

-2.1%

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Question

Which of the following is the correct way to calculate CPI?

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Answer

Total cost of this period / Total cost of base period X 100

Show question

Question

What does CPI calculate?

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Answer

The price of goods in a market basket

Show question

Question

Who calculates CPI?

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Answer

Bureau of Labor Statistics

Show question

Question

Calculate the CPI for 2021. Let's say you bought two items each year. The quantity of the items is constant at 20.

2020:

Milk: $3

Eggs: $6

2021: 

Milk: $5

Eggs: $9

Show answer

Answer

155

Show question

Question

Calculate the CPI for 2021. Let's say you bought two items each year. The quantity of the items is constant at 10.

2020:

Milk: $2

Eggs: $3

2021: 

Milk: $6

Eggs: $7

Show answer

Answer

260

Show question

Question

The rate at which prices fall is known as...

Show answer

Answer

Deflation

Show question

Question

The rate at which prices increase is known as...

Show answer

Answer

Inflation

Show question

Question

The rate at which prices increase at a slower rate is known as...

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Answer

Disinflation

Show question

Question

CPI in 2021 is 109.3; CPI in 2020 is 104.4


What is the inflation rate?

Show answer

Answer

4.7

Show question

Question

CPI in 2021 is 112.5; CPI in 2020 is 109.4

Calculate inflation rate.

Show answer

Answer

2.8

Show question

Question

True or False: Calculating CPI alone will give us the inflation rate.

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Answer

False

Show question

Question

True or False: CPI helps us calculate the inflation rate.

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Answer

True

Show question

Question

True or False: If inflation increases without an increase in nominal wages, real wages go up.

Show answer

Answer

False

Show question

Question

Nominal wages went up 13%, inflation went up 15%. Calculate real wage.

Show answer

Answer

-2%

Show question

Question

True or False: Real values are the absolute or actual numerical values of a variable in different periods.


Show answer

Answer

False

Show question

Question

True or False: Real values account for changes in purchasing power.

Show answer

Answer

True

Show question

Question

True or False: substitution bias is an issue with CPI.

Show answer

Answer

True

Show question

Question

True or False: The cost of living is the required amount of money a household needs in order to cover basic living expenses such as housing, food, clothing, and transportation.

Show answer

Answer

True

Show question

Question

If nominal wages go up 12% and inflation goes up 12%, what is the real wage?

Show answer

Answer

0

Show question

Question

If nominal wages go up 12% and inflation goes up 10%, what is the real wage?

Show answer

Answer

2%

Show question

60%

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