What is the Consumer Price Index?
Consumer Price Index is a measure of the average price of a basket of commodities commonly used by people relative to a base year. The base year CPI is marked as 100 and the CPI for the year which the measure is calculated is either below or more than 100 thus marking whether the average price has increased or decreased over the period.
Consumer Price Index (CPI) Formula
Consumer Price Index (CPI) formula for a given year is given by:
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For eg:
Source: Consumer Price Index (CPI) (wallstreetmojo.com)
Examples
Let us consider the following examples.
Example #1
Let us suppose the market basket consists of 5 items: maize, corn, bread, wheat, clothes. The quantity and prices for the base year (here taken as 2010) and the current year (2018) is as below
| Item | Quantity | Price in Base Year (2010) | Price in Current Year (2018) |
|---|---|---|---|
| Maize | 100 | $10 | $13 |
| Corn | 50 | $12 | $15 |
| Bread | 50 | $8 | $10 |
| Wheat | 150 | $5 | $8 |
| Clothes | 25 | $15 | $19 |
Let us calculate the price of the market basket in the base year and the current year.
Market Basket in the Base Year –
Market basket in base year (2010) = 100*10 + 50*12 + 50*8 + 150*5 + 25*15
- = $ 3125
Market Basket in the Current Year –
Market basket in current year (2018) = 100*13 + 50*15 + 50*10 + 150*8 + 25*19
- = $ 4225
CPI will be –
CPI Formula = 4225/3125 X 100
- = 132.5
The price index for the base year will always be 100 since the Consumer Price Index for that year is divided by the same year
Consumer Price Index for base year = 3125/3125 x 100 = 100
Example #2
CPI for the United States of America. As per the Bureau of Labour Statistics, the CPI rose 2.2% for the twelve-month period from November 2017 to November 2018. The CPI includes the prices of food, energy, commodities like apparel, vehicles, alcoholic beverages, smoking products, and other services like shelter, medical and healthcare services, and transportation.
source: bls.gov
Example #3
A country had four items on its CPI index viz. Food, Clothes, Education, Fuel. The Country has the year 2000 as the base year for measuring Consumer Price Index and the government in the year 2005 wants to see if the purchasing power of the people of the Country has improved or deteriorated. The price of each item is as below.
| Item | Quantity | Price in Base Year (2010) | Price in Current Year (2018) |
|---|---|---|---|
| Food | 30 | 38 | 42 |
| Clothes | 20 | 43 | 40 |
| Education | 30 | 35 | 38 |
| Fuel | 20 | 60 | 55 |
Now, calculating the market basket of for each year and then calculating the CPI we get,
Market Basket Base year – 2000
Market Basket Base year – 2005
Consumer Price Index
Thus, the CPI for the year 2005 is 101.18 which shows that inflation has slightly increased thus the purchasing power of the consumers has slightly decreased.
Relevance and Use of Consumer Price Index
CPI is used as an economic indicatorEconomic IndicatorSome economic indicators are GDP, Exchange Rate Stability, Risk Premiums, Crude Oil Prices etc. read more and a measure of inflation in the economy. It acts as a proxy to the policies of the government which intends to keep inflation low so as to provide a better purchasing power to the people of the Country. The changes in the CPI guide the government and policymakers to make suitable decisions for the betterment of the economy.
CPI can be used in the following ways:
- As an indicator of the economy helpful for policymakers to make informed decisions
- As a deflator for various other economic indicators like the retail sales, earnings, etc. so as to make them comparable to the base year
- As a measure of the purchasing power of the consumer, the price rise decreases the purchasing power of the customers
- It can be used as an adjusting factor for a wage increase, minimum wage levels, etc.
- It is used as an index to check on the social schemes of the government and to adjust the cost of living levels of the people
Conclusion
CPI measures the weighted average price of the basket of goods and services usually consumed by the consumers. It measures the level of increase or decreases in the price from the base year with base CPI as 100. CPI for the calculating year, if more than 100 means the prices are higher than the base year and if less than 100 means that the prices are lower than the base year. Thus, it is a widely used measure of inflation which helps as an indicator of the government policies and state of the economy of the Country.
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