Consumer Price Index (CPI)
What is Consumer Price Index (CPI)?
The Consumer Price Index (CPI) is a price index tracking the cost of a fixed basket of goods a typical household buys, with the base year set to 100.
The Consumer Price Index (CPI) is a statistical measure that tracks the weighted average of prices of a basket of goods and services consumed by households. It is used to measure inflation, which is a sustained increase in the general price level of goods and services in an economy. The CPI is calculated by comparing the current prices of the basket of goods and services to a base period. This helps to determine the percentage change in prices over time.
Consumer Price Index (CPI): a worked example
A survey finds a typical household buys 10 loaves of bread and 5 shirts, and those quantities are then held fixed. In the base year bread costs $2 and a shirt costs $20, so the basket costs 10 × $2 + 5 × $20 = $120. In Year 2 bread is $3 and a shirt is $24, so the identical basket costs 10 × $3 + 5 × $24 = $150. CPI for Year 2 = ($150 / $120) × 100 = 125, meaning prices sit 25 percent above the base year. In Year 3 the same basket costs $162, giving a CPI of ($162 / $120) × 100 = 135. Inflation between Year 2 and Year 3 is (135 - 125) / 125 × 100 = 8 percent, not the 10 index points separating the two readings.
The mistake students make with consumer price index (cpi)
The basket gets quietly updated. Asked for CPI in a later year, students recompute the quantities to match what households buy now, because that feels more realistic than pricing an outdated shopping list. Doing so folds a quantity change into a number meant to isolate price change, and the result no longer measures inflation. Hold base year quantities fixed and vary only the prices. The frozen basket is also the source of substitution bias, since the index keeps charging households for the old quantity of a good after they have switched to cheaper alternatives.
Consumer Price Index (CPI) questions
How do you calculate the inflation rate from CPI?
Inflation between two years equals the change in the index divided by the earlier index, times 100. With a CPI of 120 in one year and 126 the next, inflation is (126 - 120) / 120 × 100 = 5 percent. Subtracting alone gives 6 index points, which is not a percentage, so the division step is what earns the mark. When the earlier year is the base year at 100, the shortcut works, since a reading of 126 is simply 26 percent above base.
What does a CPI of 100 mean?
A CPI of 100 marks the base year, the reference point the whole index is built around. Every other year is priced relative to that basket. A reading of 145 says the same basket costs 45 percent more than it did in the base year, and a reading of 92 says it costs 8 percent less. Statistical agencies choose the base year and can move it, which rescales every index number without changing the underlying pattern of price movement.
Why does CPI overstate inflation?
Three biases push the measure up. Substitution bias comes from the fixed basket, which keeps buying the old quantity of beef after households switch to chicken when beef gets expensive. Quality bias records a price rise as pure inflation even when the newer model does more. New product bias leaves goods out of the basket until they are already common and their price has fallen from the launch level. Together they make the measured cost of living rise faster than the true cost of holding a standard of living steady.
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Common comparisons
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