Consumer Price Index Lecture Notes

Consumer Price Index (CPI)

• Measures the overall level of prices.
• It gauges the overall cost of goods and services bought by a typical consumer.
• The Bureau of Labor Statistics (BLS) is the entity responsible for its calculation.

Calculating CPI

1. Fix the basket:
   • Select goods and services most important to the typical consumer.
2. Find the prices:
   • Collect prices at each point in time.
3. Compute the basket’s cost:
   • Use the same basket of goods & services over time.
   • Isolate the effects of price changes.

• Expenditures in year 1 are calculated as:
  • (Price in year 1) X (Quantity in year 1) and added together for all goods and services.

1. Choose a base year and compute the CPI

   • Base year = benchmark
   • The formula to calculate CPI is:
     CPI in current year = \frac{Expenditures\,in\,current\,year}{Expenditures\,in\,base\,year} × 100
   • CPI in year 2:
     CPI\,in\,year\,2 = \frac{Expenditures\,in\,year\,2}{Expenditures\,in\,base\,year} × 100
   • CPI in year 1:
     CPI\,in\,year\,1 = \frac{Expenditures\,in\,year\,1}{Expenditures\,in\,base\,year} × 100

2. Compute the inflation rate

   • The formula to calculate the inflation rate is:
     Inflation\,rate\,in\,year\,2 = \frac{CPI\,in\,year\,2 - CPI\,in\,year\,1}{CPI\,in\,year\,1} × 100

Typical Basket of Goods and Services

• The figure illustrates how the typical consumer divides spending among various categories of goods and services.
• The Bureau of Labor Statistics calls each percentage the “relative importance” of the category.

Problems in Measuring the Cost of Living

• Substitution bias
  • Prices do not change proportionately.
  • Consumers substitute toward goods that have become relatively less expensive.
• Introduction of new goods
  • More variety of goods becomes available.
• Unmeasured quality change
  • Changes in quality of goods and services.

Producer Price Index (PPI)

• Measure of the cost of a basket of goods and services bought by firms.
• Changes in PPI are often thought to be useful in predicting changes in CPI.