Definition: The consumer price index or CPI measures the changes in the price of a certain collection of goods and services bought by consumers in an effort to measure inflation. In other words, it measures the change in a basket of consumer goods like medicine, groceries, and transportation as a benchmark to gauge the cost of living and inflation.
What Does CPI Mean?
This measurement is a very important metric that is used by economists, institutions, and companies. Economists use the CPI to measure the price changes in bread, milk, meat, and other essentials to see if consumer’s purchasing power is changing or staying the same. Based on the findings, economists might recommend an expansionary or contractionary fiscal policy to correct the changes in price.
Besides economists, many investments are indexed to the CPI as a proxy for inflation, such as Treasury bonds, government securities, and other items, so as the average price of the items in the index goes up, the investments attached to them change as well.
Let’s look at an example.
Alex is an economist at the Federal Reserve, and he wants to measure the impact of the recent changes in milk, meat, and bread. Let’s say the Consumer Price Index currently consists of milk, meat, bread, and apples, all of which are bought in equal quantities.
Looking at market data, Alex sees that apples have stayed constant at $1, whereas milk has increased from $2 to $4, meat has increased from $3 to $6, and bread has actually decreased from $3 to $1. Alex calculates that this translates to a 0% increase in the price of apples, a 100% increase in the price of milk and meat, and a 200% decrease in the price of bread. He also calculates that the consumer paid $9 for the basket before the changes, but $12 after the price changes. Dividing 12 by 9, and multiplying by 100, he arrives at a CPI of 133. Since CPI is normally based at 100, he sees that prices have increased 33% for consumers due to the recent changes.
Obviously, this is a simplistic example, but it follows the same method that economists use to calculate CPI. In practice, however, the calculation is much more complicated because there are thousands of goods and brands included in the basket. Also, the chosen goods in the basket tend to change due to consumer budgets and aren’t distributed amongst consumers evenly like in our example. This creates a large challenge for economists, and typically takes a large portion of the year to accurately calculate.