Consumer Price Index
The purpose of this paper is to look upon the concept of Consumer Price Index. The uses and the users of this index will also be discussed in this paper. Then its calculations, its determination and the estimating weights will be looked upon. A common product from the goods of basket will be selected and a brief historical analysis of its consumer price index will be discussed.
Consumer Price Index
In the early 1930s, when the United States was undergoing an economic depression, babe Ruth made an extraordinary salary of US$ 80,000 which was greater than the salary of President Hoover, which was US$ 75,000. However, today an average player of basketball can earn ten times as much salary as Ruth did and an extraordinary player may earn up to 100 times more. This is because of the basic fact that the prices of goods and services have increased in the period of 1930 to 2010. 1931 was a time when movie theater cost was a quarter for a ticket and ice-cream’s cost was a nickel. Therefore in order to compare and contrast the salary of Ruth with the current salaries, there is a need of an instrument that can turn the dollar amounts into a measure to determine the purchasing power then and now. This is why Consumer Price Index is used, to calculate the measure of purchasing power of a typical person.
According to the Bureau of Labor Statistics (BLS) of the United States, the Consumer Price Index (CPI) is the relative importance of each product and the product category. It measures the changes in price of the same basket of goods and services, within the same country, from one period to another. CPI is the overall cost of the services and goods bought a typical American from the market basket. Usually the CPI for a country is calculated each month. Every month the BLS calculates the CPI and develops a report on it. The market basket of goods and services is the sample of typical consumer’s purchases for everyday living (Bureau of Labor Statistics).
The meaning of CPI is explained in a different way by Investopedia.com as it relates CPI to a measure that takes into inspects the weighted average prices of the basket of services and goods of a typical consumer, like milk, bread, health care and car fuel. For the calculation of CPI, the changes in prices of the goods in the basket are determined and are averaged. The goods and services are weighted to give them relative importance. The CPI is sometimes also referred to as the headline inflation as it is the inflation in the common household products that a person in a country needs to live his life. Two types of CPI measures are calculated by the BLS of United States. One is the CPI for the urban earners combined with the clerical workers and the second one being the CPI for all the urban earners.
The second type of CPI is known to be a better measure as it represents the typical American worker and accounts for the 87% of the population. Fattening of CPI during a small period of time represents a period of inflation whereas the diminishing of CPI in a short period of time shows deflation in the economy. Hence, CPI is one of the most used instruments for the determination of inflation or deflation in an economy (Investopedia).
Users and Uses of CPI
The basic use of CPI is to measure and inspect the changes in the cost of living over a period of time. When the CPI rises over a period of time, a typical family will have to increase their expenditure in order to maintain the standard of living. This is because the market basket of goods and services has become expensive or some goods or services in this basket have become expensive. CPI is used by the economists to analyze the inflation or deflation in an economy. The term inflation is used by the economists to describe a period where the prices of the goods in the market basket have increased. The rate of inflation is also calculated from the CPI and it is defined as the change in price levels from a period in the past. CPI is also used by the government officials who develop the macroeconomic policies. This is because the CPI is the determinant of inflation which is in turn the key variable that guides the macroeconomic policies of the economy (Mankiw).
Diewerts from the University of British Columbia describes three uses of Consumer Price Index. The first use is the use of CPI as the Cost of Living Index (COLI), which is the measure of relative costs in two periods in order to achieve the standards of living when the prices of the same market basket of goods and services are different in two periods. The second purpose of CPI is its use as a consumption deflator which is the breaking down of value ratio into quantity and price components to measure the price change component. The third use of CPI mentioned is its use as a determinant of general inflation (Diewert). CPI is widely used as an economic indicator for the internal and external politicians, private firms and the households. Hence it is the measure of the effectiveness of the policies of a government and how far it is successful in controlling inflation. Moreover, the businessmen, private citizens and the leaders in labor market use the CPI to make decisions of whether to invest or not, whether to demand a pay rise or not and whether to reduce or increase the expenditure.
CPI is also sometimes used as a deflator of other economic indicators such as the Gross Domestic Product (GDP). Hence, the components of CPI and CPI itself are used to for the purpose of adjustment of other economic series to tune the price changes and for the translation of these indicators into inflation free measures. CPI is also used in the United States for the purposes of escalation agreements. These escalation agreements are developed to compensate for the changes in prices in a period. In the private sector, escalation agreements are used for rental contracts, child support payments, collective bargaining agreements, insurance policies with inflation protection and alimony support. This is basically done in order to keep the payments or income in line with the changes in the prices of general goods and services.
More than 2 million labors are tied in escalation contracts with the employers that related their wages with CPI. This index affects 80 million Americans’ income as a result of legislative action by the government. This includes the beneficiaries of Social Security, the retirees from military and Federal Service and the great number of food stamp recipients. The students who consume lunch at school are also affected by the CPI changes. Since the last 25 years, the Federal income tax structure is also being adjusted by using CPI to prevent the increases of tax rate because of inflation. The base payment is clearly defined in an escalation agreement that is subject to escalate, such as the rent, child support, the wage or any other value. These base payments are changed according to the percentage change in the points of CPI between the initial point and the stated subsequent point. This is computed by first calculating the change in index points between the two periods and then the change in percentage. Hence, the escalation agreements can be easily formed using CPI as the factor (Bureau of Labor Statistics).
Determination of CPI
The CPI is calculated at the end of each month by the BLS in Untied States. BLS gets involved in the collection of information on prices of goods and services from 23,000 retail stores and service providers as an initial step in the calculation of CPI. The businesses are chosen on the basis of the information provided by the sample of 14,500 families. Sales taxes are included in the calculation CPI but the income tax and investment prices such as bonds and stocks are not included. CPI also excludes the sale price of houses instead the rent is included as a monthly cost of living in a home (Amadeo).
The BLS uses the data and prices of thousands of services and goods before calculating the CPI and the rate of inflation. The first step in calculating the CPI is to determine the goods and services that are the most essential for the typical consumer. The basket of goods and services is decided and fixed in the first step. To make the determination of CPI more simple and understandable, we will assume that we are calculating the CPI in an economy where only two goods are consumed by the citizens. Let us assume the two goods to be milk and bread. In the economy, if a typical consumer buys more of milk than bread, then the sensitivity of price of milk is more important to the general public than the price of bread. Hence, the weight of milk should be greater in the calculation of CPI. These weights are computed by conducting surveys in markets and by finding the basket of goods that are more important to the general public.
The second step in the computation of CPI is finding the prices of all the good and services accurately that are included in the market basket of goods. The prices are found for each product for each period. The third step is to compute the overall cost of basket of goods. The prices of the individual goods are used to calculate the overall cost of the basket of goods at different points in time. In this calculation, each year the change is due to the change in prices because the basket of goods remains the same. The effects of price changes due to the changes in the quantity are eliminated.
The main step is then to select a base year and compute the index of consumer price. A single year is designated as a base year. This base year is the benchmark with which the other years are compared and contrasted. To calculate this index, the overall price of the basket of goods and service is divided by the overall price of the basket in the base year. This index value is then multiplied by hundred to get a percentage value. This resulting value from the calculations is the Consumer Price Index. In the example of milk and bread, let us consider the price of the basket this year to be US$ 8.00. The price of the basket in all the years will be divided by $8 and then multiplied by hundred to get the index. 2001 is selected to be the base year and hence the price index is 100 in this year.
If the index comes to be 175 in 2002, this will mean that price of the basket in 2002 is 175% of the price of the basket in 2001. In other words, the basket of goods that cost $100 in 2001 would cost $175 in 2002. Similarly, if the index is found to be 250 in 2003, then this shows that the price level of the basket of goods was 250% of the price of same basket in 2001 (Mankiw). The rate of inflation can also be calculated from this CPI. Inflation rate can be calculated as the change in percentage in the price index from the last year. This means that inflation rate is the change in CPI between two periods.
Cigarette – Historical Analysis of CPI
1997 was taken as the base year for the calculation of CPI of cigarettes in the United States. Therefore the CPI was 100 in 1997 for cigarette in United States. The following table shows the CPI indexes of cigarette for six year starting from the base year of 1997.
The table shows that the prices of cigarettes in the United States have been increasing since the base year 1997 and the CPI reached 192 in 2003. This was because of the rise in the taxation on sale of cigarette. This step was taken by the government of the United Stated in order to reduce the habit of smoking in the youngsters. Another reason for the rising prices was the rising costs of the retailers and wholesalers. The cigarette manufacturers also raised the prices of cigarette from their side in order to cover the costs of law suits. The manufacturers had no other choice but to pass on this increase in costs to the consumer. The rising wages of the workers in the factories and the employees in the offices of these manufacturers also added to the cost rise of cigarette (Harris).
Is CPI Accurate?
The inclusion of rental prices is very misleading in the calculation of CPI. This is because the rental prices usually fall when there are a lot of vacancies and the rent goes up when the vacancies are low. The rental prices are also affected by the interest rates and the house prices. When the interest rates are low and the selling prices of houses are on the rise, the rental prices fall. On the other hand, when the prices of houses fall, and interest rates are high, the rental prices increase because of the demand. Hence, the CPI index can give a false low value when the prices of houses are high, the rents being low, and a false high value when the prices of houses are lower, rents being high (Amadeo).
To an extent, the CPI is accurate, but the errors in sampling and persistent bias can cause the CPI to be inaccurate many times. The sample is selected from a population and hence if there are any errors in selecting the samples, the CPI will prove to be inaccurate. Time lags in collecting the data and in calculating the CPI will not take into account the rise in price in this lag. Hence, the price index will not be accurate and current. The inaccuracies in the data collection of the price from retail stores and sellers can also cause the CPI to be inaccurate (Bureau of Labor Statistics).
Amadeo, K. Consumer Price Index (CPI Index). 3 January 2010. 9 August 2010 <http://useconomy.about.com/od/economicindicators/p/CPI.htm>.
Bureau of Labor Statistics. BLS Information. 28 February 2008. 9 August 2010 <http://www.bls.gov/bls/glossary.htm>.
Diewert, E. “The Consumer Price Index and index number purpose.” Journal of Economic and Social Measurement 27 (2001): 167-248.
Harris, J. THE PRICE OF CIGARETTES AND THE PROFITS OF CIGARETTE MANUFACTURERS WITH AND WITHOUT FEDERAL INTERVENTION, 1997–2006. Academic. Massachusetts: MIT-Department of Economics, 1998.
Investopedia. Dictionary. 2010. 9 August 2010 <http://www.investopedia.com/terms/c/consumerpriceindex.asp>.
Mankiw, G. Principles of Microeconomics. Fifth Edition. USA: South-Western Cengage Learning, 2009.