Measuring Inflation: Consumer

Price Index

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Measuring Inflation: The
Consumer Price Index

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Inflation

• Measures the rate of CHANGE in prices.

• Is calculated from a price index, for
different time periods: months, quarters,
years.

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Price Index

A price index is a number that

represents overall prices for a
given period of time –say a year-.

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The Consumer Price Index
• Principal source of information for trends in
consumer prices and inflation.
• Used for escalation of contract amounts and
payments among individuals and organizations.
• Used to adjust payments to:
– Social Security recipients
– Federal and Military retirees
– Food Stamps and School Lunches
• Used to adjust individual income tax brackets.

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The Consumer Price Index
I
CP

The CPI is a measure of prices for a fixed

basket of goods and services of
constant quantity and quality
purchased by consumers.
Measures the overall cost of the goods
and services bought by a typical
consumer.

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 Current Market Basket
•For the current CPI, information was collected from
the Consumer Expenditure Survey over the three years
1993, 1994, and 1995.

•In each year, more than 5,000 families from around

the country provided information on their spending
habits in a series of quarterly interviews.

•To collect information on frequently purchased items

such as food and personal care products, another
5,000 families in each of the 3 years kept diaries listing
everything they bought during a 2-week period.
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The CPI 3 trips

1. Fix the basket:

select the most 1 computer
commonly
purchased items
by conducting
surveys. 5 Doctor visits

2 tuitions

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The CPI
Ticket = $600

2. Find the prices of

the items included
in the basket:
scouts go every Computer=$1200
month looking for
these prices.

Doctor Visit=$100
Tuition =$20,000

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The CPI
3 Tickets = $1800

3. Compute the cost of

the items in the
basket each year.

1 Computer= $1200

5 Doctor Visits= $500

2 Tuitions = $40,000

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Cost of the Basket Y2000
2T
1 Computer $20 uitions
,0 0
0/e
$1,200/ea a
5 Docto
r visits
3 tickets $100/e
$600/ea a

$500
$1, 8 00 $43,500 $40
, 000
$1,200

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 Ticket Price in
The CPI 1995 = $500
4. Choose a base year
-the benchmark for
comparison- and
compute the cost of
the basket in the Computer Price in
base year…Say 1995 1995 =$1500

Doctor Visit in
Tuition in 1995 1995 =$90
=$20,000
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 Cost of the Basket in the
Base Year (1995)
Note: Same items, 2T
same quantities, same
1 Cweom puforter $20 uitions
qualities used ,0 0
0/e
1,500/ea
$2000 a
5 Docto
r visits
3 tickets $90/ea
$500/ea

450
0 $
$1,50 $43,450 $40
,0 00
$1,500
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The CPI

5. Compute the CPI.

Cost of Basket in 2000 x100

CPI (Year 2000) =
Cost of Basket Base Year

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Calculating the CPI
1. Fix the quantities and items in the
basket.
2. Find the prices of these items.
3. Compute the cost of the items in the
basket at each year’s prices.
4. Choose a base year -the benchmark for
comparison-
Cost of Basket in 2000 x100
CPI (Year 2000) =
Cost of Basket Base Year
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Updating the Market Basket

• CPI revisions occur approximately every

10 years.
• The most important revision is the
introduction of a new “market basket”
• The last revision to the CPI started in
1998 and completed in 2000.

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 What goods and services
does the CPI cover?

All goods and services purchased for

consumption are classified into 200
categories, arranged into eight major
groups.
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 The CPI includes

• FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken,

wine, full service meals and snacks);
• HOUSING (rent of primary residence, owners' equivalent rent, fuel
oil, bedroom furniture);
• APPAREL (men's shirts and sweaters, women's dresses, jewelry);
• TRANSPORTATION (new vehicles, airline fares, gasoline, motor
vehicle insurance);
• MEDICAL CARE (prescription drugs and medical supplies,
physicians' services, eyeglasses and eye care, hospital services);
• RECREATION (televisions, cable television, pets and pet products,
sports equipment, admissions);
• EDUCATION AND COMMUNICATION (college tuition, postage,
telephone services, computer software and accessories);
• OTHER GOODS AND SERVICES (tobacco and smoking products,
haircuts and other personal services, funeral expenses).

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Although not a “price” CPI
includes…
• Also included are various government-charged user fees:
– water and sewerage charges, auto registration fees, and vehicle
tolls.
• The CPI also includes taxes:
– such as sales and excise taxes that are directly associated with
the prices of specific goods and services.
• The CPI excludes taxes:
– such as income and Social Security taxes that are not directly
associated with the purchase of consumer goods and services.
• The CPI does not include investment items:
– such as stocks, bonds, real estate, and life insurance. Because
these items relate to savings and not to day-to-day consumption
expenses.

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 Total spending by households %

Transportation
Other services
7%
7%Medical
Household 5%
services
9%
Food and
Beverages
18%

Rent
26%
Apparel
6%

Non durables
Durables 11%
11%

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 The Core Consumer Price Index
Measures what consumers are paying for goods and
services at malls, grocery stores and other retail
locations.

Unlike the overall CPI, it excludes food and energy

prices, which can bounce around enough each month to
distort the overall price trend picture.

Buyers should pay attention to the report because it's

one of the most important indicators of inflation. High
inflation equals high interest rates. Low inflation allows
interest rates to fall.

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Inflation

• Inflation refers to an INCREASE in

the price level from one period to the
next.
• Inflation can be high (20%) or low
(2%)
• When inflation drops from 20% to 2%
prices still INCREASE, but not as
much as the previous time period.

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Deflation

• Deflation refers to a DECREASE in the price

level from one period to the next.
• Deflation shows up as a NEGATIVE number
for the inflation rate: a –5% “inflation” means
that prices DECREASED by 5%.
• This is not only a slowing down of inflation but
a DROP in prices.

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The GDP Deflator vs.
The CPI

GDP Deflator reflects the prices of all

goods and services produced
domestically bought by consumers,
the government and other countries.

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The GDP Deflator vs. The CPI

The CPI reflects prices of goods

purchased by consumers only. The CPI
does not take into account prices of
goods and services bought by the
government or foreigners.

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 The GDP Deflator vs. The
CPI
2. The CPI uses a fixed basket whereas
the GDP deflator uses prices of
currently produced goods.

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3
2

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Comparing dollar values
from different years

$100 in 1930 is not the same as $100 in

2000.
Why not?
Because prices were different: $100 used to
buy you more then…
To compare $100 in 1931 with $100 today we
must find out what $100 used to buy in
1930 and compare that to what $100 buys
today..
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Example

If you want to know what is the equivalent in

today’s dollars of an $80,000 salary in 1931,
1. Find the ratio of prices:
CPI in 2000 / CPI in 1931 = 172.2/16.7 = ___10.31
2. Multiply 80,000 by that # =________
824,910.2
An $80,000 salary in 1931 is equivalent to a
$_________salary
824,910.2 in 2000.

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Problems Measuring the
Cost of Living

1. Substitution Bias: Because the basket is

fixed, the CPI does not account for
substitutions consumers do in response
to higher prices.
 Substitution away from “KFC” to “chicken-
like KFC”.

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Problems with CPI…

2. New Goods Bias: new goods mean greater

variety and thus consumers need to spend
less to attain the same (or higher) standard
of living. CPI does not reflect this change in
the purchasing power of a dollar.
3. Unmeasured Quality change: If quality
improves, the value of the dollar rises.

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