Consumer Price Index (CPI) Explained – Calculation and How Does it Work
The Consumer Price Index (full form – CPI) is the combined estimate of the price levels of various goods and services in an economy. It generally refers to goods and services usually purchased for mass consumption.
Understanding the CPI is crucial for understanding the country’s economy’s overall health along with its prospects and challenges. Let’s delve deep into the topic.
What is the Consumer Price Index (CPI)?
The Consumer Price Index (CPI) can prove to be a handy tool for understanding the consumption behaviour of the masses. The CPI is one of the most recognised methods to evaluate inflation by policymakers, economists, businessmen, and consumers. The CPI measures the general change in the pricing of consumer goods and services over a period of time.
For a nation, the CPI is an essential tool to track the price of everyday consumable goods or services. They cover products related to FMCG (mainly food), clothing, transportation, and other goods and services consumed by the masses daily. The CPI is a numerical estimation created by the prices of particular items into account over a particular time. The CPI is used as the benchmark to adjust wages, salaries, and pensions.
The price index is usually calculated monthly or quarterly, depending on the country and its policies. Member countries of international organisations like the Organisation for Economic Co-operation and Development (OECD) use CPI for estimating inflation.
How Does the Consumer Price Index (CPI) Work?
The price of various products and services calculated as per CPI for inflation is considered against the prices of those goods and services during other months. The goods and services considered for determining the inflation index include common goods and services, called the market basket.
The CPI is used to measure the purchasing power of the masses and how much a consumer would spend to be on par with the change in pricing to maintain their standard of living.
Note that the CPI is a price inflation index for consumer goods and is used to calculate retail inflation and is different from WPI (Wholesale Price Index), which is used to calculate wholesale inflation.
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How is the Consumer Price Index Measured?
The Reserve Bank of India (RBI) and other financial institutions study the CPI to recognise the price change of different products and keep an eye on the CPI inflation.
The CPI is measured using a base year which acts as the starting point. The price change is measured relative to the base year. To calculate the CPI, we consider the basket’s cumulative price in 1 year and divide it by the price of the market basket of the base year. The result is multiplied by 100 to arrive at the final CPI value.
Formula to Calculate the Consumer Price Index
The CPI is calculated by dividing the Cost of the Market Basket in a given year by the Cost of the Market Basket in Base Year and multiplying it by 100. Here’s the formula:
The market basket is developed using comprehensive expenditure information. The information is gathered via surveys of individuals, households, and businesses. Governments spend considerable resources and time to precisely gather the expenditure information and accurately calculate the CPI.
Benefits of Consumer Price Index
Here is a list of some of the most important consumer price index uses and benefits:
- CPI acts as an economic indicator (variables used to deduce a nation’s economic health) as it helps determine the purchasing power of the consumers and the currency.
- It is also an indicator for assessing the effectiveness of the government’s economic policies.
- CPI data helps make adjustments to other economic indicators based on price changes. It also allows the components like national income to be adjusted.
- The CPI allows modifications to the cost of living for the wage and salary earners and those who benefit from the social security programs to offset any increase in the prices caused by an upsurge in inflation.
Limitations of Consumer Price Index
Although measuring CPI in a country is immensely advantageous, it also comes with a few drawbacks. Some of these include:
- The CPI may not apply to the entire population of a nation. Generally, the CPI is estimated based upon the consumption patterns of the urban demographics (CPI-U, U stands for urban) and does not consider the rural population that is large in number.
- CPI does not generate estimations for subgroups in a population.
- CPI is an indicator that estimates the cost of living on a conditional basis and does not calculate every aspect that impacts the standard of living.
- The societal and environmental factors are not within the comprehensible scope of the index.
What is CPI Inflation?
Over the years, the CPI has emerged as a popular method to calculate price inflation and is used as a macroeconomic indicator by the Government of India and the Reserve Bank of India (RBI). They use the CPI to check the price inflation and plan their economic policies based on it. The Government and the RBI use the CPI to supervise price stability and as a deflator in national accounts.
Inflation is the change in the average price of products and services at regular intervals. It represents the purchasing power of a unit of a country’s currency concerning the difference in the price of various products and services. An increase in prices of different commodities and services would mean a decrease in the currency’s purchasing power and vice versa.
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Latest Update on CPI Inflation
- Globally, the inflation rate has surged due to the recent geopolitical developments, which have caused an increase in the global inflation rate.
- The rise in inflation can be seen in many developed nations, like the US and the UK. Currently, the CPI inflation rate for both US and UK stands at 9.1% respectively.
- The inflation rate in both the US and the UK is at its highest since November 1981, indicating a reduction in the purchasing power of both the dollar and the pound and a substantial decrease in the purchasing power of US and UK citizens.
- In India, the CPI inflation rate for June 2022 was 7.01% which came down from 7.04% in May 2022. It was, however, at its highest during April 2022 at 7.9%, which is the highest CPI inflation rate in 8 years.
- India’s CPI inflation rate being above the 7% mark is higher than the RBI-mandated 4% CPI Inflation rate with a margin of 2% on either side. A Higher CPI inflation rate would mean a reduction in the purchasing power of the consumers and a decrease in the value of the Indian currency over time.
Final Word
The Consumer Price Index is a crucial indicator for banks, governments, and financial institutions to understand an economy’s inflation rate and price index changes. The consumer price index uses multiple variables and calculation methodologies to determine the retail inflation rate for a particular month or quarter.
The CPI is designed to estimate the overall changes in the pricing of selected goods and services purchased by the masses mainly for their individual or domestic consumption.
FAQs
Ans. When the CPI inflation rate for selected goods and services increases, there is a proportionate reduction in the currency’s purchasing power. The masses would now have to spend more capital on maintaining their lifestyle or would do the opposite and reduce their purchases of leisure items and focus on basics.
Ans. No, CPI is not the only actual measurement of inflation. CPI is beneficial in tracking the changes in consumer spending patterns as the price changes and the retrospective change in the purchasing power of the consumers.
Ans. CPI does not measure the price change in rural, regional or remote areas. The CPI also does not consider the stark difference in spending patterns among individuals and households because the spending pattern of households is way different from individuals.
Ans. The CPI covers all goods and services that are purchased for consumption either by households or individuals and includes food and beverages, housing, fuel and light, clothing and footwear, pan, tobacco, and intoxicants. Housing is not included under the CPI retail inflation rate.
Ans. Based on the report in 2001 by the National Statistical Commission led by Dr C. Rangarajan, starting from January 2011, the Consumer Price Index would replace the Wholesale Price Index for consumption-based inflation for rural, urban, and combined.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
