HOW IS THE CONSUMER PRICE INDEX CALCULATED?

How the Consumer Price Index Is Calculated

• Fix the Basket: Determine what products are most important to the typical consumer.– The Bureau of Labor Statistics (BLS) identifies a

market basket of goods and services the typical consumer buys.

How the Consumer Price Index Is Calculated

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

• Reminder: the basket of goods doesn’t change!!– Only concerned with price changes!

3 Steps to Calculate CPI for any year (x)

• Step 1 Calculate cost of basket for base year• Cost of basket (base year) = Prices (base year) * Quantities (base year)

• Step 2 Calculate cost of basket in year x• Cost of basket (yr X) = Prices(yr X) * Quantities (base year)

• Step 3 Calculate CPI yearXCPI (yrX)= Basket (yrX)/Basket (base year)

• Reminder: To calculate the cost of each year’s basket, don’t change the quantities, ONLY CHANGE THE PRICES!

How the Consumer Price Index Is Calculated

CPI (yr X) = Price of the Basket (yr X) X 100 Price of the Basket (base year)

HISTORICAL CPI! So, what is the value of the CPI in the Base Year?

100

How the Consumer Price Index Is Calculated

Compute the inflation rate: The inflation rate is the percentage change in the CPI from the preceding period.

• The Inflation Rate– The inflation rate is calculated as follows:

In fla tio n R ate in Y ear 2 =C P I in Y ea r 2 - C P I in Y ea r 1

C P I in Y ea r 1 1 0 0

Dollar Figures from Different Times• Do the following to convert (inflate) Babe

Ruth’s wages in 1931 to dollars in 2001:

S ala ry S a la ryP rice lev e l in 2 0 0 1

P rice lev e l in 1 9 3 12 0 0 1 1 9 3 1

$ 8 0 ,.

$ 9 3 1,

0 0 01 7 7

1 5 2

5 7 9

CPI DEFLATOR

CPI Deflator 2001

CPI Deflator 1931

Table 1 Calculating the Consumer Price Index and the Inflation Rate: An Example

Copyright©2004 South-Western

The quantity stays the same each year!

2.Find the prices

3. Calculate the cost of the original basket in each year.

4. Divide each basket into the base year basket to find the CPI.

5. Calculate change in CPI to find inflation rate

Quantity Hot Dogs

4

3

2

Quantity Hamburger

2

2

1

“Inflate or Deflate” PricesYou can put the price of any good from any year into another year’s dollar value by calculating how much the CPI grew or shrunk over that time period.For instance:Question: Has minimum wage kept up with inflation?Minimum Wage in 1965 = $1.25/hrCPI in 1965 = 31.5CPI in 2013 = 233

$ 1.25 “inflated” to 2013 prices =1.25 x 233/31.5 = $9.25

Problems in Measuring the Cost of Living

• Substitution bias• Introduction of new goods• Unmeasured quality changes

Problems in Measuring the Cost of Living

• Substitution Bias– The basket does not change to reflect consumer

reaction to changes in relative prices.• When prices go up, consumers switch to cheaper

alternatives.• The index overstates the increase in cost of living by not

considering consumer substitution.

Problems in Measuring the Cost of Living

• Introduction of New Goods– The basket does not reflect the change in

purchasing power brought on by the introduction of new products.• New products result in greater variety, which in turn

makes each dollar more valuable.• Consumers need fewer dollars to maintain any given

standard of living.

Problems in Measuring the Cost of Living

• Unmeasured Quality Changes– If the quality of a good rises from one year to the

next, the value of a dollar rises, even if the price of the good stays the same.

– If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.

– The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

Problems in Measuring the Cost of Living

• The CPI is NOT a perfect measure of the cost of living.

Most problems with CPI result in inflation being measured as too high!

For Example: Ford Fusion ($28,000) vs. Model T ($19,000 in today’s money). - was that caused by inflation?

The GDP Deflator versus the Consumer Price Index

• The GDP deflator reflects the prices of all goods and services produced domestically, whereas...

• …the consumer price index reflects the prices of all goods and services bought by consumers, even imported goods

• (so when the $ changes value, that effects CPI)