11.1 The Consumer Price Index

11.1 a. How the CPI is calculated

Example: Let’s compute the CPI for Country B. In this simplified example, consumers in Country B only purchase bananas and jackets. The first step is to fix the basket of goods. The typical consumer in Country B purchases 5 bananas and 2 jackets in a given period of time, so our fixed basket is 5 bananas and 2 jackets. The second step is to find the prices of these items for each time period. This data is reported in the table, above. The third step is to compute the basket’s cost for each time period. In time period 1 the fixed basket costs (5 X $1) + (2 X $6) = $17. In time period 2 the fixed basket costs (5 X $2) + (2 X $7) = $24. In time period 3 the fixed basket costs (5 X $3) + (2 X $8) = $31. The fourth step is to choose a base year and to compute the CPI. Since any year can serve as the base year, let’s choose time period 1. The CPI for time period 1 is ($17 / $17) X 100 = 100. The CPI for time period 2 is ($24 / $17) X 100 = 141. The CPI for time period 3 is ($31 / $17) X 100 = 182. Since the price of the goods and services that comprise the fixed basket increased from time period 1 to time period 3, the CPI also increased. This shows that the cost of living increased across this time period. ^[2]

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. ^[1]

^{Calculating CPI [3]}

11.1 b. Problems in Measuring the Cost of Living

Some problems with measuring the cost of living through CPI are: ^[4]

• The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living.
• The basket does not change to reflect consumer reaction to changes in relative prices.
• The basket does not reflect the change in purchasing power brought on by the introduction of new products.
• If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.
• The CPI overstates inflation by about 1 percentage point per year.

^{Problems with CPI [5]}

11.1 c. The GDP Deflator vs the Consumer Price Index

The consumer price index is not a representative of the general rate of inflation in the economy. The first problem with the consumer price index is that it’s not a comprehensive measure of price changes. That is, it considers only the bundle of goods and services that households typically buy. The GDP deflator, on the other hand, is a broader measure that includes all kinds of goods and services produced in the economy, and is therefore probably a better measure of inflation. ^[6]

Another problem of CPI is because of the substitution bias, the consumer price index overstates changes in the cost of living. The GDP deflator, on the other hand, is a broad measure, and includes all goods and services, and therefore allows some room for substitution. Also, CPI does not factor in effects in prices because of new products, shopping patterns and quality changes. So the consumer price index as measured by the price of this particular bundle of goods and services may overstate inflation. And some researchers say that the actual degree of overstatement may be as much as 1 percentage point to 1.5 percentage points. ^[6]

Example: If the measured inflation rate is 3%, it may be that the cost of living is actually only rising by about 1.5 or 2% a year. The CPI overstates this however, because of the negligence in changing patterns, markets and introduction of newer products. For this reason, the Federal Reserve, which makes monetary policy for the United States, tends to focus more of its attention on changes in the GDP deflator, rather than the changes in the consumer price index. The changes in the GDP deflator are probably a more reliable measure of the overall inflation rate in the country. ^[6]

^{CPI and GDP Inflator [7]}