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.

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.

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.

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.

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.

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.

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:

$InflationRateinPeriod3=\frac{CP{I}_2-CP{I}_1}{CP{I}_1}\times 100=\frac{110.7-104.7}{104.7}\times 100=5.73\%$

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.

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

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!

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.

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?

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 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!

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.

Fig. 1 - Brazil CPI. Aggregate growth shown here measures changes in annual total CPI with base year 1980

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.

Fig. 2 - CPI for Hungary vs USA. CPI shown here includes all sectors. It is measured annually and indexed to base year 2015

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.

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.