Macroeconomics - The Consumer Price Index & Inflation

Inflation
Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same. Inflation can also be defined as a decline in the real purchasing power of the applicable currency.

Consumer Price Index (CPI)
The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This data is used to compare the prices for a particular month with the prices from a different time period.

Example:
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year, dividing that difference by last year's CPI value and then multiplying by 100.

So if the value of the price index for the current year is equal to 165, and last year's value was 150, the rate would be calculated as:

Inflation rate = (165 - 150) X100= 10
150

CPI Sources of Bias
The CPI is not a perfect measure of inflation. Sources of bias include:

·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price increases may reflect quality adjustments that are still counted entirely as inflation.

·New goods - new goods may be introduced that will be hard to compare to older substitutes.

·Substitution - if the price goes up for one good, consumers may substitute another good that provides similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting discount or outlet stores.

Aggregate Supply & Aggregate Demand


Related Articles
  1. Options & Futures

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  2. Retirement

    Economic Indicators: Consumer Price Index (CPI)

    By Ryan Barnes Release Date: Monthly, approximately mid-month Release Time: 8:30am Eastern Standard Time Coverage: Previous ...
  3. Forex

    Inflation

    An in-depth look at inflation
  4. Economics

    Should You Worry About the U.S Inflation rate?

    Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
  5. Forex

    How CPI Affects the Dollar Against Other Currencies

    The Consumer Price Index is a broad measure of inflation, and inflation can have a dramatic impact on a currency's value against rival currencies.
  6. Retirement

    Inflation: How Is It Measured?

    Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market ...
  7. Forex

    The Consumer Price Index

    Find out how this economic measure can help you make key financial decisions.
  8. Fundamental Analysis

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  9. Investing

    Three Reasons Inflation Isn’t What You Think

    Though U.S. inflation has been firming recently— the core consumer price index rose in April for a 3rd month in a row—prices likely aren’t rising as much.
  10. Retirement

    Inflation: What Is Inflation?

    Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys ...
RELATED TERMS
  1. Consumer Price Index - CPI

    A measure that examines the weighted average of prices of a basket ...
  2. Headline Inflation

    The raw inflation figure as reported through the Consumer Price ...
  3. Chain-Weighted CPI

    An alternative measurement for the Consumer Price Index (CPI) ...
  4. Inflation Targeting

    A central banking policy that revolves around meeting preset, ...
  5. Basket Of Goods

    A relatively fixed set of consumer products and services valued ...
  6. Inflation Protected

    The types of investments that provide protection against inflation ...
RELATED FAQS
  1. What are some limitations of the consumer price index (CPI)?

    Explore some of the basic limitations of the widely used economic indicator, the consumer price index, or CPI, and examine ... Read Answer >>
  2. How does the Bureau of Labor Statistics determine the Consumer Price Index (CPI)?

    Changes in the average price level of more than 200 goods and services across the U.S. economy are used to determine the ... Read Answer >>
  3. Does the consumer price index (CPI) correlate with the change in price of goods and ...

    See why the consumer price index is a questionable proxy for inflation, and why it is unlikely to represent experiences with ... Read Answer >>
  4. Will the consumer price index (CPI) be updated or revised in the future?

    Learn about the consumer price index (CPI) and understand how its purpose and calculation make it necessary to continually ... Read Answer >>
  5. What's the highest year-over-year inflation rate in the history of the U.S.?

    Learn about periods with the highest inflation in U.S. history and the mandated role of the U.S. Federal Reserve in controlling ... Read Answer >>
  6. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center