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In the current mood of global inflation and possible recessions, it’s important to understand the economic lingo that goes around.
What is the federal funds rate?
What is a trade deficit? What is the Consumer Price Index or CPI?
In this article, we will provide a detailed explanation about CPI and how to calculate it.
CPI or the Consumer Price Index is a measure of inflation created by the BLS or Bureau of Labor Statistics.
It is used worldwide.
The index was formally created in 1919 but data on food prices started to come through since 1913.
At first, six major groups were used to price the CPI: food, clothing, rent, fuel, house furnishings and miscellaneous.
Over a hundred years, the index has been continuously improved upon in terms of enhanced methodology; updated samples and weights; and expanded coverage.
Source : Markus Wrinkler (Pexels)
Today, the CPI is created with 94,000 monthly price quotes collected from 23,000 retail and service establishments.
While we cannot show you how the actual CPI is calculated, this article will use a simple example to show the process behind creating a CPI.
To calculate CPI, you need a base year first.
The base year could be 1918, 1956, 1999 or any year in our calendar.
The base year is simply used as a reference point to calculate how far prices have grown.
For simplicity, the base year’s CPI is locked at 100.
Secondly, you need a basket of goods.
A basket of goods is composed of market items at a set price.
The goods can be everyday items used by consumers such as milk, chicken, bread etc.
For this example, we will use chocolate, coffee and cigarettes for our basket of goods.
Let’s assume the average person would consume 40 packs of cigarettes, 5 boxes of coffee and 25 chocolate bars in a year.
Let’s take the base year as 1982 and fix prices for the following:
Keep in mind these are base year prices.
Now to calculate CPI, the first step is to add the value of these goods along with their quantities.
We’ll call this a market basket value.
Market Basket Value (1982) = ($2 x 40) + ($5 x 5) + ($1 x 25)
= $130
So the market value of a basket of goods in 1982 is $130.
When the actual CPI is calculated, a much larger basket is used, with thousands of goods in higher quantities.
Now to find the CPI for 2022, we need to know the prices for chocolates, cigarettes and coffee in 2022.
Let’s assume that the average person in 2022 consumes the same amount of these goods as they did in 1982 but the prices have increased.
Let us calculate the market basket value of these goods at 1982 quantities.
Market Basket Value (2022) = ($3 x 40) + ($7 x 5) + ($2 x 25)
= $205
Now we have the information we need to calculate CPI. Remember the base year’s CPI (1982) is 100.
Here is the formula to calculate 2022’s CPI.
(Market Basket Value in 2022 / Market Basket Value in 1982) x Base year CPI (1982) = CPI in 2022
($205/$130) x 100 = 157.6 ~ 158
So, the CPI for 2022 is 158.
We can calculate inflation from this value as well using another formula.
(158-100)/100 = 58/100 = 0.58 = 58%
We have an inflation rate of 58% which means that over a 40-year period, prices have increased by 58%.
Once you try this method yourself using different goods and quantities, you can understand CPI better.
This article is sourced from the following links:
Why Is the Consumer Price Index Controversial? (investopedia.com)
Consumer Price Index (CPI) Definition (investopedia.com)
Consumer Price Index Frequently Asked Questions : U.S. Bureau of Labor Statistics (bls.gov)
How to calculate the CPI and inflation rate: (uvm.edu)
History : Handbook of Methods: U.S. Bureau of Labor Statistics (bls.gov)
