In this video you will learn about the consumer price index.
It is a method to measure inflation that is commonly used throughout the world.
Each country examines different sets of data, but uses a similar approach.
Before explaining the CPI it is important to understand what a market basket it.
The market basket is a fixed set of goods and services whose prices are used to calculate
changes in prices year on year.
The goods and services in the basket vary by country due to differing consumption habits
and also have different weightings.
The consumer price index is measured by analysing the price of the goods and services in that
market basket.
Well now that we know the CPI is measured by looking at changes in the prices of the
market basket, let’s see how it’s actually done.
Let’s look at a series of years and the nominal prices of the same market basket in
each year.
We’ll start with 1990 and use it as our base year.
By base year I mean it will be the year against which we compare changes in price.
It is the beginning year for this set of data.
In the second column we list the nominal prices of the market basket each year.
You can see a trend of increasing prices and we’ll use this information in the final
column to calculate our price index.
The CPI is calculated by dividing the current price of the market basket by the market basket
of the base year, which is then multiplied by 100.
It’s also very important to remember that the CPI is not a percentage so we don’t
add a percent sign afterwards.
Applying this formula to each year we are able to arrive at the consumer price index
from 1990 to 2005.
I’ve used simple calculations to illustrate but you may see some examples that are slightly
more complicated than this.
By looking at the CPI over years, we can calculate the inflation rate.
Let’s see how that works.
In this table we’ll layout the same years and the CPI we calculated for each year.
As we’re always comparing to the base year, we’ll also calculate inflation for each
year compared to the base year of 1995.
When calculating the inflation rate, it’s vital that you subtract the CPI of the comparison
year from the CPI of the new year and then divide by the value of the comparison year.
We don’t always calculate inflation against a base year, and it’s far more common to
see year on year comparisons of inflation as well as monthly comparisons.
The information provided in this slide is just to act as an illustration.
The following inflation rates have been calculated for each year.
We always include the percentage sign when calculating the inflation rate.
Always ensure that you’re calculations are written out as such if necessary.
Don’t skip any steps in your work when responding to exam questions.
Although these calculations help provide us with a picture of inflation and how prices
are changing, there are some issues surrounding the use of CPI as a measure of inflation.
The ‘typical household’ does not represent every household
The market basket used in the CPI is based on purchases made by a typical household.
It’s not an exact science and since we tend to buy different goods and services, the CPI
does not apply equally to us all.
2.
Product substitution - as goods and services become more expensive people switch away from
them.
For example, if beef becomes more expensive, people may start consuming lamb.
Therefore the CPI can overstate inflation if it accounts for goods and services that
people are consuming less of due to increases in price.
3.
Consumption of new products is unaccounted for - the market basket updates but may not
include new products that people are using more frequently.
It takes time to catch up to consumption trends so the CPI will not always capture new goods
and services.
4.
Changes in quality - If certain goods increase in price but also increase in their lifetime
use, it is not accounted for in inflation.
If products bought this year last longer, then their per use price could work out lower
than the previous year product’s per use price.
The CPI does not account for this.
5.
Outlet substitution - As the price of goods and services rise, people may change where
they buy these new items.
Whereas before they may have purchased certain goods from supermarkets, they may now be shopping
at discount outlets, online stores and food wholesalers.
That brings us to the end of our session on the consumer price index.
While there are other ways to measure inflation, the CPI is the focus for the CIE syllabus.
You should also be familiar with the GDP deflator which was referenced in the nominal vs real
data video earlier in the inflation series.
As always, I hope you found this video helpful in developing your understanding of the CPI
and the methods by which to measure inflation.
If you have any questions leave them in the comments below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition.
That’s us done for now and I will see you in the next one!