Economists often need to calculate various expenditures made by households to understand the nature and condition of the economy. As inflation and deflation are key terms that dictate the well-being of economies, the related factors such as Consumer Price Index (CPI) become very important terms for them.
The consumer price index is a measure of the prices of household goods and services. The price often keeps changing and hence the government bodies (the Bureau of Labor Statistics in the US) that keep track of CPI calculate CPI on a regular basis (for example, every month in the US).
To calculate the CPI, the weighted average cost of the goods and services of a particular basket of a certain period is divided by the weighted average cost of goods in the previous period. The obtained figure is multiplied by 100 to get the actual CPI in percentage terms.
Therefore,
$$\mathrm{CPI = \frac{Cost \: of \: baskets \: in \: the \: current \: period}{Cost \: of \: baskets \: in \: the \: previous \: period} \times 100}$$
Sometimes, the CPI is also published for a year when there is a need to check large volumes of data.
For example, according to the BLS in the US, the percentage change in monthly CPI from March to April, 2022 was 0.3% while CPI from March 2021 to April, 2022 was 8.3% YOY (Year Over Year).
The CPI considers a cross-section of goods and services that are commonly bought by households to compare whether the expenses have gone up or down. This gives the measure of inflation and deflation depending on the increase or decrease of average prices of the goods and baskets considered in CPI. In the US, the most influential impact5 on CPI is contributed by housing and commodities.
CPI is calculated as the best reflector of inflation.
To calculate CPI, the statisticians collect data on the prices of thousands of items, which are divided into various categories and groups.
The price change is noted for the previous period and the current period
Then these price changes are used to calculate inflation for the entire gamut of the basket of goods and services.
To compile the data for calculating CPI, statisticians collect data from –
statisticians collect data from various sources, such as supermarkets, malls, retailers, departmental stores, and household shops.
Government bodies, energy providers, and real-estate agents' data are also being collected for the purpose of calculation of CPI.
Some data that change frequently are collected on a daily or weekly basis while other forms of data are collected on a monthly, quarterly, or yearly basis.
The goods and services chosen for the calculation of CPI depend on the frequency of use of the product. The weighted average form of one item that is more frequently used would be more than other items that have low consumption patterns. The calculation is often based on how much and what is being consumed by the households. That is why some special items may be included in the CPI calculation when they are bought increasingly by the households.
For example, the inclusion of smartphones may be necessary when households buy them to take advantage of technology increasingly.
Underlying Inflation
Although most statistical agencies calculate CPI to calculate headline inflation, sometimes, calculation of underlying inflation may be necessary. The indicators of underlying inflation ignore the larger sets of data or the data of items that are consumed too much. This happens because, sometimes, the large data obtained for some items are for temporary factors which are temporary which may not affect the economy substantially.
Following are some examples of underlying inflation:
Supply shortage due to bad weather: Supply shocks may trigger high inflations. The lack of some items in an economy may suddenly increase the prices of goods and commodities.
This is, however, temporary which makes the higher prices last for a short duration of time.
Casual changes in the tax regime: High taxes that are introduced by central authorities may change the prices of some select goods. This is however not applicable to the entire basket of goods and services.
This is therefore a reason for underlying inflation.
In general terms, inflation means CPI-based inflation.
The CPI usually tracks the changes in the rate of prices and thereby the rate of inflation. It is a matter of serious concern for the central government authorities because high inflation is detrimental to economies.
An economy can both suffer from inflation and deflation depending on the price changes in CPI. When the prices go up, it is inflation. So, when inflation rises, the CPI also goes up. On the other hand, in the case of deflation, the CPI value goes down.
The CPI is calculated depending on the price changes of particular commodities which are divided into various categories, such as urban, semi-urban, and rural categories. It is notable that since the consumption patterns of these categories are highly different, the effect of inflation on CPI will be huge.
The CPI is based upon selected goods and service baskets. So, when the inflation hits the items that are out of consideration of CPI, the inflation will not disrupt CPI. However, in most cases, inflation impacts CPI because the most influential consumer goods are included in CPI which is hit primarily during inflation.
In other words, Inflation refers to an increased level of CPI when the prices of goods and services increase while negative inflation refers to diminishing CPIs. So, we can say that the relationship between inflation and CPI is directly proportional.
CPI is important because it is the best tool to measure the inflationary and deflationary phases of an economy. As is obvious, the central authorities, such as the Reserve Bank of India in the Indian economy would be primarily interested in maintaining the CPI at a stable level.
However, it is easier said than done. Without active coordination between the market forces and the controlling authority, inflation may occur at any time. Therefore, the organizations such as the Reserve Bank must keep vigilance over the CPI.
CPI is not easy to be monitored perfectly. Since loopholes in data collection may lead to errors in calculating CPI, there are chances of errors in measuring the exact inflation via calculation of CPI. However, all statistical bodies take care to report the most accurate data of CPI by using various statistical methods in general.
1. What is the best mode of calculation of inflation and deflation in an economy?
Ans. The best mode of calculation of i9nflation and deflation is the Consumer Price Index CPI which shows the price of a selected basket of goods and services.
2. Is there any set timeframe for the calculation of CPI?
Ans. CPI can be measured daily, weekly, quarterly, monthly, and yearly. Some authorities even calculate CPI every five years.
3. Is CPI an indicator of the price level?
Ans. CPI is an indicator of price change but it does not show price levels. One cannot compare the prices of two items by using CPI. For example, if the price of a Banana is rupees 60 per dozen and the price of Mangoes is 120 per kg, one cannot say that a Banana is cheaper than Mangoes.
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