Consumer Price Index

The prices of goods such as food, housing, and gas fluctuate from year to year.   An increase in the overall price level of goods and services is known as inflation, while a decrease in price levels is deflation.  To measure price fluctuations, the Bureau of Labor Statistics chooses a basket of goods which reflects the average spending patterns of urban consumers.  This basket is known as the Consumer Price Index, or CPI-U, and is the most common measure of price levels.

The CPI includes goods and services such as food, apparel, housing, transportation, education, entertainment, and medical care.  Goods such as gas and food are weighted more heavily than theater tickets since consumers must purchase them more frequently.  CPI is then calculated by taking the percentage increase or decrease of current price levels from price levels of a chosen base year.  Below is a graph of five different country’s CPI levels using 2000 as the base year:

This graph shows that Germany, Greece, the UK, and the US experienced inflation from 2000 to 2012 as price levels were continuously increasing.  Japan is the exception since the Yen deflated over this time period.  Yearly inflation or deflation rates are calculated using this CPI data by calculating the percentage change for each year.  The graph below shows the inflation and deflation rate of these countries during this time period:

 

Most of these country’s inflation rates hovered between 2 and 3%, which is generally the rate targeted by the Federal Reserve and European Central Bank.  The large decrease in inflation at the end of 2008 is from the collapse of the housing bubble as prices for many good in the CPI decreased. 

 

The CPI is the most common measure of price levels, but it is not a perfect measurement.  First, the CPI does not account for increases in the price of goods purchased by firms and governments (the Producer Price Index does).  Second, CPI does not account for substitution bias.  If apples are part of the basket, and the price of apples increases dramatically, consumers could substitute them for oranges and the CPI would not account for the switch.  Thirdly, there are some arguments that the CPI overstates inflation since a fixed basket cannot adjust for substitution, the introduction of new goods into the market, and changes in quality of goods.

 

These complications aside, the CPI is extremely useful for monitoring fluctuations in price and is frequently used by firms, governments, and central banks to make policy decisions.