Consumer Price Index
(CPI)
The consumer price index or CPI is a more
direct measure than per capita GDP of the standard of living in a country. It
is based on the overall cost of a fixed basket of goods and services bought by
a typical consumer, relative to price of the same basket in some base year. By
including a broad range of thousands of goods and services with the fixed
basket, the CPI can obtain an accurate estimate of the cost of living. It is
important to remember that the CPI is not a dollar value like GDP, but instead
an index number or a percentage change from the base year.
Constructing the CPI
Each month, the Bureau of Labor Statistics
publishes an updated CPI. While in practice this is a rather daunting task that
requires the consideration of thousands of items and prices, in theory
computing the CPI is simple.
The CPI is computed through a four-step
process.
1. The fixed basket of
goods and services is defined. This requires figuring out where the typical
consumer spends his or her money. The Bureau of Labor Statistics surveys
consumers to gather this information.
2. The prices for every
item in the fixed basket are found. Since the same basket of goods and services
is used across a number of time periods to determine changes in the CPI, the
price for every item in the fixed basket must be found for every point in time.
3. The cost of the fixed
basket of goods and services must be calculated for each time period. Like
computing GDP, the cost of the fixed basket of goods and services is found by
multiplying the quantity of each item times its price.
4. A base year is chosen
and the index is computed. The price of the fixed basket of goods and services
for each comparison year is then divided by the price of the fixed basket of
goods in the base year. The result is multiplied by 100 to give the relative
level of the cost of living between the base year and the comparison years.
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.
Changes in the CPI
over time
As we have just seen, the CPI changes over
time as the prices associated with the items in the fixed basket of goods change.
In the example just explored, the CPI of Country B increased from 100 to 141 to
182 from time period 1 to time period 3. The percent change in the price level
from the base year to the comparison year is calculated by subtracting 100 from
the CPI. In this example, the percent change in the price level from the base
period (time period 1) to time period 2 is 141 - 100 = 41%. The percent change
in the price level from time period 1 to time period 3 is 182 - 100 = 82%. In
this way, changes in the cost of living can be calculated across time.
Problems with the CPI
While the CPI is a convenient way to compute
the cost of living and the relative price level across time, because it is
based on a fixed basket of goods, it does not provide a completely accurate
estimate of the cost of living. Three problems with the CPI deserve mention:
the substitution bias, the introduction of new items, and quality changes.
Let's examine each of these in detail.
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