It is important for economists to understand when an economy is facing price changes as substantial price changes could cause inflations or deflations which harm the health of an economy. To understand how much inflation an economy is faced with, economists measure the percent increase in price levels relative to the previous year. Economists have created two distinct index systems which measure the change in prices from one year relative to another. Using these index systems, economists can calculate an inflation rate measuring the percent change in price levels in two distinct years. Each of the two index systems have different ways to measure the change in price therefore yield slightly different inflation rates. These index systems are referred to as “price indices”. Each price index measures the total price of a collective set of goods and services. This collective set of goods and services are referred to as a “market basket”. Each price index has a unique market basket. Let’s introduce both of the price indices. The first price index is called the “Consumer Price Index (CPI)” and the second price index is called the “GDP Deflator”. In this article we will be looking at the “Consumer Price Index (CPI)”.
This index system measures the change in prices of a certain unique market basket. What is inside this market basket? An organization known as the “Bureau of Labor and Statistics (BLS)” is responsible for recording statistics of economies. This organization runs a survey every year to measure the most common goods and services bought by typical urban consumers. These commonly bought goods and services are then categorized based upon the type of good it is. For example, there might be one category consisting of all foods and another category consisting of all transportation goods. Finally, the BLS picks the top most commonly bought goods and services from each category and these goods and services are selected to be included within the market basket. Now that the market basket has been created, its price must be determined. The price of the market basket is determined by adding up the total prices of all the items within the market basket. Let’s look at an example of a simplified market basket and calculate its price.
2018 Market Basket
In this table, we are given a very simplified market basket. Note that typically a market basket consists of many more items however for this example we will only be considering a market basket of four items. We notice that this market basket consists of apples, wheels, notebooks, and pencils. We are given the quantity and the price of each of these goods. To find the total market basket price, the total price of each of the goods must first be found. The total price of each good is given by multiplying the unit price with the quantity of each good. For an example, the total price of apples would be the product of 20 X 2 which yields a total price of $40. After finding the total price of each good in the market basket, we can now find the price of the market basket. We simply take the sum of the total price of each good
$40 + $35 + $150 + $60 = $285. As we can see, the market basket price in 2018 is $285. Now suppose that this same market basket in 2019 has a price of $308. Economists will use the CPI to measure the change in the price of the market basket. Here is the formula for calculating the CPI:
Consumer Price Index (CPI) = Price of Market Basket in Current YearPrice of Market Basket in Base Year X 100
In this number system, the number 100 is considered to be the base value. This means that receiving a CPI value of 100 means that there is no change in the market basket of the current year relative to the base year. The CPI of the base year is also 100. This is because if we were finding the CPI of the base year, the values for “Price of the Market Basket in Current Year” and “Price of Market Basket in Base Year” would be the same and therefore would yield 1. 1 X 100 would give us a CPI of 100 for the base year. Values greater than 100 signal an increase in the price of the market basket in the current year relative to the base year. Values less than 100 signal a decrease in the price of the market basket in the current year relative to the base year. Going back to our example, we want to calculate the CPI in 2019 relative to the base year 2018. Since 2018 is the base year we know that its CPI must be 100. Recall that the price of the market basket in the current year 2019 is $308 and the price of the market basket in the base year 2018 is $285. Let’s use the formula to calculate the CPI for 2019.Consumer Price Index (CPI) = 308285 X 100 = 108. We receive a CPI of 108. This index value may seem like some arbitrary number when determining how much prices have changed. Yes we do know that since the CPI is greater than 100, we are experiencing an increase in prices however we do not know exactly how much the increase is. This is where the inflation rate comes into play. The inflation rate will allow us to process the exact amount of change in one year relative to the previous year. We can use the CPI to calculate the inflation rate. Let’s look at the formula for calculating the inflation rate:
Inflation Rate = New CPI - Old CPIOld CPI X 100
In this formula, the “New CPI” represents the CPI of the year being studied while the “Old CPI” represents the CPI of the year previous to the one being studied. It is important to note that “Old CPI” does not refer to the CPI of the base year but rather to the year previous to the one being studied. Essentially, we can notice that this formula is just the percent change formula as that is exactly what the inflation rate is. Using the example above, recall that the CPI in 2019 was 108 and the CPI in the previous year, which in this example was also the base year, was 100. Using the formula above, we can find the inflation rate. Inflation rate = 108-100100 X 100 = 8%. As we can see, the inflation rate for 2019 was 8% based on this particular market basket. This means that prices in 2019 increased by 8% relative to the previous year 2018 based on this market basket. Now, suppose that the CPI in 2020 was 105 relative to the base year 2018. What would the inflation rate of 2020 be? We would use the inflation rate formula again. The New CPI is the CPI from 2020 which is 105. The Old CPI is the CPI from 2019 (not 2018 as this is the base year, but not the previous year) which is 108. Using the formula, we would get: Inflation Rate = 105-108108 X 100 = -2.77%. We can see that we received a negative inflation rate indicating a deflation. This means that the prices in 2020 have decreased by 2.77% relative to the previous year 2019 based on this market basket.
CPI is a helpful tool to calculate the inflation rate however it is important to address some of its shortcomings. Since the CPI only has a particular set of goods in its market basket, there could be a slight underestimate or overestimate in the inflation rate since it is not accounting for the price of every single good in the economy. Furthermore, the CPI could fail to select new goods and services within its market basket since they may have not gained as much popularity among consumers at the time of the survey. Another shortcoming of the CPI is it fails to address a change in consumer preferences. If the price of one good rises, then consumers will substitute that good for another and begin purchasing this other good instead. However, this other good will not be in the market basket and therefore could provide slight inaccuracies in the inflation rate. The CPI also fails to address the quality of the goods within the market basket. This could also lead to change in consumer preferences as consumers may begin purchasing other goods instead due to poor quality of one good. This other good may not be included in the market basket and therefore the inflation rate could yield slightly inaccurate results. As we can see, most of the shortcomings of CPI stem from its market basket as this market basket does not consider all goods and services and therefore the inflation rate may underrepresents all of the economies goods and services but still does provide a general idea of the price changes occurring within an economy. In the next article we will focus on another price index called the GDP deflator which has its own unique market basket used to also calculate the inflation rate.
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