5.2: The Consumer Price Index

Tracking changes in the cost of living is central to economic planning and policy. The Consumer Price Index (CPI) is one of the most widely used tools to gauge these shifts. Designed to represent the typical consumption patterns of urban households, CPI serves as both a snapshot of current economic conditions and a benchmark for adjusting income-based policies.

Structure and Calculation of the CPI

The CPI is constructed from a "market basket" that includes categories such as housing, food, healthcare, transportation, and recreation. Each component is assigned a weight based on household spending data collected through consumer expenditure surveys. Although commonly described as fixed, this basket undergoes periodic updates to account for evolving consumer habits.

To determine the CPI, statisticians calculate the total cost of the basket in both the current period and a designated base year. The CPI is then expressed as:

Inflation is inferred by comparing CPI values over time. For instance, the annual inflation rate can be computed as:

Limitations and Considerations

Despite its utility, the CPI is not without shortcomings. It does not adjust for quality changes in products or services—improvements in technology, for example, may offer more value without higher prices. The index also overlooks regional variations in costs, applying a national average that may not reflect local realities.

Another issue is substitution bias. When prices rise for one good, consumers often shift to cheaper alternatives, a behavior not captured by a fixed basket. As a result, the CPI may overstate the actual impact of inflation on consumer welfare.

Alternative measures, like the chained CPI, attempt to address some of these flaws by allowing for more dynamic consumption patterns. However, the traditional CPI remains a cornerstone in economic analysis due to its broad acceptance and historical consistency.

The Consumer Price Index, or CPI, measures how the average prices of goods and services change over time, specifically for urban consumers.

It’s based on a market basket that includes essentials like food, rent, clothing, transportation, healthcare, education, entertainment, and other goods and services. Each item is assigned a weight, depending on how much households typically spend on it. These weights come from national consumer expenditure surveys.

Although often called a “fixed” basket, the contents and weights are periodically updated to reflect real-world consumption patterns.

To calculate the CPI, statistical agencies choose a base year. The cost of the basket in the current year is then compared to its cost in the base year, using this formula.

The inflation rate is then calculated using the new and previous CPI figures.

The CPI helps adjust wages, pensions, and taxes, and serves as a key measure for tracking inflation.

However, CPI does not account for quality improvements or regional cost differences. Additionally, it doesn't account for substitution bias, which occurs when consumers switch to cheaper alternatives as prices rise.