The Consumer Price Index is a more direct approach of measuring the living standards in any given country compared to the per capita GDP approach. The Consumer Price Index measurement is based on the overall total cost of goods and services in a basket purchased by a typical consumer in the country, that cost is related to the prices of goods and services of that same basket in a given base year. With the inclusion of a wide range of goods and services in the fixed basket, the consumer price index can produce a precise and accurate estimation of the cost of living in the country or economy. However, the consumer price index does not give dollar values as in the GDP; instead, it gives a percentage or an index number change or difference from the base year value.
In the United States, every month the Bureau of Labor Statistics releases an update of the reviewed consumer price index. The consumer price index is used in a way that it affects the whole population in the economy. The consumer price index is used as an instrument of dollar value adjustment, an economic indicator and a deflator of related economic series. Calculation of the consumer price index involves four major steps. The first is to define the goods and services that will be included in the fixed basket. This will need the figuring out on how the typical consumers spend their money or income. The Bureau of Labor and Statistics has the responsibility of gathering such kind of information. The second step is the identification of the prices of each commodity in the fixed basket. Furthermore, because this same basket containing goods and services is used over several time periods in the determination of consumer price index changes, each commodity’s price in the fixed basket should be determined at each point in time.
The third step in calculating the consumer price index basket is to calculate the prices each commodity in the fixed basket at every point in time. Just like in the calculation of GDP, the cost of each commodity in the fixed basket is calculated by multiplying the price of the commodity by its quantity. Finally, the last step in the calculation of the consumer price index basket is the choosing of a base year and then the calculation of the index. The fixed basket’s price, which contains the goods and services for every comparison year, is divided by prices of goods and services in the fixed basket in the base year. The resulting figure is then multiplied by one hundred to find the relative cost of living level between the comparison years and the base year.
The determination of the consumer price index market basket is done by the Bureau of Labor and Statistics, (BLS). The Consumer price index basket is usually determined using very detailed information from individuals and families on how they spend their money or income and what they buy. For instance, the current consumer price index, the data was obtained from the Consumer Expenditure Surveys of 2007 and 2008. In those two years, around 7000 households from across the nation gave information in each yearly quarter about their expenditure habits in the survey. In order to collect data on frequently bought commodities like food and other personal care necessities, other seven thousand households in each of these two years kept record of each item they purchased during a fortnight period. During the two year period, spending data was obtained from approximately twenty eight thousand household records and sixty thousand quarterly interviews which were used to determine the weight or importance of the over 200 commodity categories in the consumer price index structure.
The consumer price index basket contains a wide range of goods and services. The consumer price index is a representation of all goods and services for household consumption with reference to population. The BLS classifies all commodities spent on by households into over 200 broad categories, which are then arranged into eight main groups. The eight groups are; food and beverages, transportation, housing, apparel, medical care, education, recreation and other goods and services. Another inclusion in the eight main categories are the government charged user payments like water and sewerage fees, vehicle tolls and auto registration fees. Additionally, the CPI includes excise and sales taxes which are associated with other specific commodities’ prices. The CPI however does not include taxes like Social Security and income taxes which have no direct association with consumer goods and services purchases. The CPI does not also include investment commodities like real estate, bonds, stocks and life insurance. This is because such items are savings, not daily consumption expenditures. For the over 200 commodity categories, the BLS uses a scientific statistical procedure to select specific commodities from business entities which are often visited by consumers. The sample selected is then used as a representation of the other types of items available for the consumers. For instance, they may choose to pick a 2 kilogram pack of white wheat flour to represent other kinds of wheat flour.
In the calculation of consumer price index basket, the commodity prices have to be reviewed very often. Every month, the BLS collects information from across the whole country about the prices of the various commodities that are used in the measuring and tracking consumer price index changes. The information about the price of each item is tracked on a monthly basis. If in a certain month a particular commodity is not found where it was the previous month, another commodity similar to it is recorded in its place. The collected data is then assessed and reviewed by specialists who check for consistency and accuracy in the data to identify and make necessary adjustments. This is done with the objective of avoiding drastic changes in commodities’ quality from interfering with the consumer price index basket’s ability to measure changes in price.
The calculation of the consumer price index basket involves a series of various interrelated sample products. Initially, using the information obtained from the 1990 population census, the BLS chose the urban areas from where the information on commodity prices was to be obtained. Households from different areas in the eligible urban centers were selected for collecting the vital information. The population census also provided information on the number of consumers found in each area selected for consumer price index area of price collection. Here is an example of the calculation of a consumer price index basket in a certain country, K. in this scenario, there is a simplified case where there are only two commodities in the economy that consumers purchase, corn and beef. The first procedure is to set a basket of the goods and services consumed in the economy. A typical household in this economy consumes or purchases 5 corn packets and 2 kilograms of beef in a certain period. Therefore, the fixed basket will be composed of 5 packets of corn and 2 kilos of beef.
The second step will be to establish the prices of corn and beef for every time period. Such information will be best recorded in tabular form. The third part will involve the computing of the cost of a basket at each period of time. For instance, in the first period, a fixed basket can cost (5*1) + (2*6) = $17. In the second time period, the fixed basket will cost (5*2) + (2*7) = $24. The third time period’s fixed basket will cost (5*3) + (2*8) = $31. The final step will be to select a base year then to compute the CPI basket. For instance, period 1 can be taken to be the base year because the base year can be selected from any year. The consumer price index basket for the first period will then be calculated as ($17/$17) * 100 = 100. The CPI basket for the second period will be (24/17) * 100 = 141. The CPI for the third period will be computed as (31/17) * 100 = 182. Now that the prices of goods and services that make up the fixed basket increase from one period to the next, i.e. period 1 to period 3, the consumer price index basket also went up. This indicates that the living standards increased from period one through to period three.
The consumer price index basket usually changes over time depending on the changes in the prices of the commodities that are included in the fixed basket. For example, in country K, the consumer price index basket increases from 100 to 141 then to 182 from the first period to the second then third period respectively. The percentage changes in the levels of prices from those of the base year to those of the comparison year are computed by the subtraction of 100 from the comparison year’s CPI. For example, the change in percentage in levels of prices from base period one to comparison period two is 141 – 100 = 41%. Using this approach, the living costs can be calculated over different periods of time.
Even though the CPI is convenient in computing relative price levels and living costs in an economy over time because of its basement the fixed basket of specific goods, it does not give a totally accurate estimate of the living costs. There are three major problems that affect the accuracy of the consumer price index basket compotation. They include; quality changes, substitution bias and introduction of foreign or new items. These problems affect the prices or the commodities included in the fixed basket hence causing shifts in the value of the fixed basket.
Therefore, the CPI basket computation is a very useful tool in the analysis of an economy. This would help determine the living standards in that economy as well as helping in inflation and deflation regulatory measures. The CPI basket computation helps understand how the goods and services in an economy and their prices change over time. Therefore, the CPI basket is an important economic tool which should be computed often to determine how the economy is doing in relation to past prices of goods and services.
Works Cited
Bade, Robin and Michael Parkin. Foundations of macroeconomics. 2, illustrated. Pennsylvania: Addison Wesley, 2003.
Biggeri, Luigi and Guido Ferrari. Price Indexes in Time and Space: Methods and Practice. illustrated. Munich: Springer, 2009.
Hall, Robert E and Marc Lieberman. Economics: Principles and Applications. 5. London: Cengage Learning, 2009.
