The Consumer Price Index and Its Significance

by FX EA Review
The Consumer Price Index and Its Significance

The Consumer Price Index (CPI) is one of the most important and followed statistics published by the federal government of every country. This index measures the weighted average of prices of a basket of goods and services which reveals trends of inflation within an economy. It serves as a tool to help the government and federal banks to make decisions on suitable macroeconomics policy. For example: if there is an increase in the CPI (which is a sign of inflation), the federal banks can implement a contractionary monetary policy by increasing the interest rate. The government can also employ a contractionary fiscal policy by increasing taxes. Not only does it help the government to make decisions, but the CPI also directly impacts the wallets of a country’s citizens. 

As social security and taxes are pegged to CPI, the rate of increase in this index will dictate the nominal payments to social security recipients and the government each year. The CPI is essentially a price-level indicator. This article will investigate how the CPI is calculated, whether it is effective and whether the flaws are possible in this method of measuring inflation. 

Calculating the consumer price index

The basic concept of the CPI is that it is an index that measures the change in the cost of living. A detailed expenditure chart is composed of a sample of families and individuals. The content is made up of different categories of goods and services such as food, furniture, medical care, recreational fees, or transportation. These make up a ‘basket.’ The value of a basket is the sum of all its component as represented by the following equation:

x

At a particular time, say the beginning of a year, the value of all the goods in this basket will be calculated. The price of the same basket will be measured quarterly and yearly. This new value will be compared with the price of the ‘base basket’ at the beginning of the year to measure the inflation rate. These calculations can be made using the following equation: 

CPI

X = price of the basket in the base year

Y = price of the market at any given time after

If the CPI has a value larger than 100%, the economy is in an inflationary state, and values below 100% reflect a recessionary state. These results will prompt the federal bank and government to make timely and effective macroeconomic decisions. According to many experts, a healthy economy experiences 3% – 5% inflation annually. 

Possible flaws of the CPI

Time lag

What constitutes the basket of the CPI is a result of a survey put out to a group of families and individuals? The answers to this survey are not published and considered until a later time. For example, the survey is completed in January but will not be in effect until the start of February. At this time, consumer habits and behaviors could change due to an external factor like a pandemic, as we observed at the beginning of 2020, where hand sanitizers and masks were a sudden addition. Furthermore, the taste and preferences of consumers could change radically due to consumer trends.  

Not representative of everyone

As the CPI measures the consuming habits of a small group of people in society, the rest of the data is extrapolated. The CPI is made to capture the consumer trends of the epicenter of economics in metropolitan areas. This means that it does not account for the rural areas, which also make up a big amount of the population. 

Substitution biases

The price changes from one year to another are not the same for all goods and services. During that period, one good could improve in quality leading to an increase in demand, meaning a higher increase in price, whereas another’s change could be less or opposite. The basket is fixed; therefore, the CPI does not demonstrate the change in consumer preferences. CPI does not take innovation and competition into consideration. 

When the price of a good is increased significantly, consumers will seek products with more competitive pricing. Similarly, consumers will switch to a substitute if that good has better innovation and brings more value. The value of the CPI assumes that consumers are buying the same amount of the same goods. 

Introduction of new items

The basket is fixed and does not take into account the introduction of new items. With the pandemic situation at the moment, disposable masks will make their way into the cost-of-living index. However, if we consider the ‘base basket’ to be one before 2020, the CPI is not representative of this new good. 

Changes in quality

The change in the quality of goods and services is not well-handled by the CPI. Even when the CPI experiences an overall increase, the quality of a good could deteriorate, and their price decreases. For example, over the years, with the lack of development, Nokia phones fall behind their peers. This results in less demand for this product leading to a fall in prices. This is not demonstrated in the annual change in CPI. 

Not cover all the goods are covered

By definition, the CPI represents items obtained by households. This is not representative of investment options such as stocks, cryptocurrency, or the price of land. Therefore, if it is not a useful source to consider for someone who considers the rewards of investments. 

CPI’s effectiveness

Although there are flaws, CPI is still used often because it is the most effective tool available at the moment. It gives the government and the federal bank a good indication of the rate of inflation and helps guide them to a suitable policy.

In the last few years, the process of determining the basket to calculate CPI has been revised several times to negate the imminent flaws. One of these is that the base baskets are being renewed quarterly to account for changes in consumer habits.  

The flaws require governments and federal banks to be more considerate and flexible when it comes to their policy-making, as the results might not reflect the real state of the economy. 

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