Consumer Price Index

In 2005, the median player on the New York Yankees was paid $5.8 million and shortstop   was paid $26 million. At first, this fact might lead you to think that baseball has become vastly more lucrative over the past seven decades. But as everyone knows, the prices of goods and services have also risen. In 1931, a nickel would buy an ice-cream cone, and a quarter would buy a ticket at the local movie theatre.

Economists use gross domestic product (GDP) to measure the quantity of goods and services that the economy is producing. This article examines how economists measure the overall cost of living.

We need to find a way of turning money figures into meaningful measures of purchasing power. That is exactly the job of a statistic called the consumer price Index. After seeing how the consumers price Index is constructed I discuss how we can use such a price index to compare dollar figures from different points in time.

The consumer price Index is used to monitor changes in the cost of living over time. When the consumer price index rises, the typical family has to spend more dollars to maintain the same standard of living. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period.

Inflation is a closely watched aspect of macroeconomic performance and is a key variable guiding macroeconomic policy. This article provides the background for that analysis by showing how economists measure the inflation rate using the consumer price index.

The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. Each month, the Bureau of Labour Statistics (BLS), which is part of the Department of Labour, computes and reports the CPI.

How the Consumer Price Index is calculated?

When the Bureau of labour statistics calculates the consumer price index and the inflation rate, it uses data on the prices of thousands of goods and services. To see exactly how these statistics are constructed let’s consider a simple economy in which consumers buy two goods: hot dogs and hamburgers.

Determine which prices are most important to the typical consumer. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important the price of hamburgers and therefore should be given greater weight in measuring the cost of living.   The Bureau of Labour Statistics sets these weights by surveying consumers and finding the basket of goods and services that the typical consumer buys.

Find the prices: Find the prices of each of the goods and services in the basket for each point in time.

Compute the basket’s cost: Use the data on prices to calculate the cost of the basket of goods and services at different times. The table shows this calculation for each of the 3 years. Notice that only the prices in this calculation change. By keeping the basket of goods the same (5 hot dogs and 2 hamburgers), we are isolating the effects of price changes from the effect of any quantity changes that might be occurring at the same time.

Choose a base year and compute the index. Designate one year as the base year, which is the benchmark against which other years are compared. (The choice of base year is arbitrary, as the index is used to measure changes in the cost of living). Once the base year is chosen the index is calculated as follows:

CPI= Price of basket of goods and services / Price of basket in base year X 100

That is, the price of the basket of goods and services in each year is divided by the price of the basket in the base year, and this ratio is then multiplied by 100. The resulting number is the consumer price Index

Compute the inflation rate: Use the consumer price Index   to calculate the inflation rate, which is the percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows:

Inflation rate in year 2 = CPI in year 2 – CPI in year1 / CPI in year 1 X 100

In addition to the consumer price index for the overall economy, the BLS calculates several other price indexes. It reports the Index for specific metropolitan areas within the country (such as Boston, New York, and Los Angeles) and for some categories of goods and services (such as food, clothing and energy). It also calculates the producer price index (PPI) which measures the   cost of a basket of goods and services bought by firms rather than consumers. Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the producer price index are often thought to be useful in predicting changes in the consumer price index.

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