Consumer Price Index (CPI)

Introduction: The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.

Key Uses of CPI:

• Inflation Tracking: The CPI is the most widely used measure of inflation, indicating how the purchasing power of currency and income erodes over time due to rising prices.
• Cost of Living Adjustments (COLAs): Social security, pensions, and wages may be adjusted annually based on changes in the CPI to maintain purchasing power.
• Economic Policy: Governments and central banks use the CPI to make decisions about monetary policy, including interest rates adjustments to control inflation.

Components and Calculation:

• The basket of goods is updated periodically to reflect changing consumer habits.
• CPI calculations can vary by type (e.g., CPI for Urban Consumers, CPI for Wage Earners) to provide more specific insights.
• The index is typically presented as a relative number compared to a base year, indicating overall price movement rather than absolute price levels.

Limitations of CPI:

• May not accurately reflect the cost of living changes for all demographic groups due to the fixed consumption pattern assumed.
• Some critics argue that CPI overestimates or underestimates real inflation due to methodological issues like substitution bias, quality adjustment, and new product introduction.