Indicator 7 – Consumer Price Index

18 Jul

The Consumer Price Index (CPI) attempts to be a direct measure 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 (the current standard reference base period is 1982-84 = 100).

Price data are collected for over 180 categories, which Bureau of Labor Statistics (BLS) has grouped into 8 major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. By including a broad range of thousands of goods and services within 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 it is instead an index number (or percentage change) from the base year.

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.

Substitution Bias: as the prices of goods and services change from one year to the next, they do not all change by the same amount. The number of specific items that consumers purchase changes depending upon the relative prices of items in the fixed basket; but since the basket is fixed the CPI does not reflect consumer’s preference for items that increase in price little from one year to the next.

Introduction of New Items: as time goes on, new items enter into the basket of goods and services purchased by the typical consumer. But since the CPI uses only a fixed basket of goods, the introduction of a new product cannot be reflected. Instead, the new items are left out of the calculation in order to keep time period comparable with earlier time periods.

Quality Changes: when an item in the fixed basket of goods used to compute the CPI increases or decreases in quality, the value and desirability of the item changes. This change would not be reflected in the CPI from one year to the next.

As a cost of living index, CPI is the most widely watched and used measure of the U.S. inflation rate. It is also used to determine the real gross domestic product (GDP).

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