Consumer Price Index (CPI)

 Definition

What is the Consumer Price Index?

Inflation refers to a persistent and sustained increase (or decrease) in the general level of prices in an economy. There are many different measures of inflation, ranging from sectoral inflation in industries such as health care or higher education, to inflation in the cost of materials and wholesale goods purchased as inputs by firms. If income or gross domestic product (GDP) rises we may not know to what extent this represents an increase in purchasing power or simply the effects of inflation. For example, if your salary rises by 50 percent from January 1997 to January 2007, to what extent are you better off as compared to 1997? As it ends up, the inflation rate (for all urban consumers) during this period was about 27.23 percent, and so while your inflation-adjusted or real income increased a large share of your increased income went toward paying higher prices.

Perhaps the most important measure of inflation is the Consumer Price Index (CPI), which measures inflation for the typical market basket of goods and services purchased by households. The CPI is commonly used to track changes in the cost of living for typical households. The CPI is calculated by selecting a fixed "market basket" of goods and services-groceries, electricity, shoes, and so on-and tracking the overall price of this fixed market basket over time. For example, if the market basket cost \$10,000 in January 1997, and the same market basket cost \$12,723 in January 2007, then the inflation rate from January 1997 through January 2007 would be [2,723/10,000]*100 = 27.23 percent.

The CPI is computed as follows:

1. Select a base year and compute the total price of the market basket in that year. The U.S. Bureau of Labor Statistics currently uses the years 1982-1984 as the base years for its calculations.

2. Compute the total price of the market basket in some future year.

3. Divide the total price of the market basket in the future year by the total price of the market basket in the base year, and then multiply by 100.

Note that the CPI starts at a value of 100 in the base year. The rate of change in the CPI provides a way of measuring the inflation rate in consumer prices. Since the CPI in December 2004 has reached 191, we can conclude that the consumer price level has increased by 91 percent since 1982-84.