THE CONSUMER PRICE INDEX

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THE CONSUMER PRICE INDEX

• ISP 120 - FALL 2001
• Dr. Ayse A. Sahin

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What is inflation?

• Inflation is a decline in the value of money in
  relation to the goods that it can buy.
• Who cares about inflation?
• We all do planning retirement, saving for a
  college education, taking out loans...

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Its hard to compare prices from one year to the
next. For example

• The average cost of a Chevy (full size) was
  2,529 in 1962 and 22,500 in 1998.
• Absolute increase
• 22,500-2,52919,971
• Percentage increase
• 19,971/2,529 ? 7.90,
• in other words approximately 790

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Now lets look at a McDonalds burger

• The average cost was .28 in 1962 and 2.69 in
  1998.
• The absolute change
• 2.69-.28 2.41
• The percentage increase
• 2.41/.28 ? 8.61, approx. 861

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How to make sense of these two pieces of data?

• So the average cost of a burger went up by 861,
  and the average cost of a car went up by 790.
• Which should we use as the inflation rate?
• Another complication
• Cars in 1998 were better (more fuel efficient ,
  safer..) than in 1962 so it is actually not clear
  if it costs more in 1998.

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Summary of problems

• Commodities may change over the years (improve or
  deteriorate) so we are not really comparing the
  cost of the same items.
• Different commodities increase/decrease in value
  at different rates. Which rate are we supposed
  to use as the inflation rate?

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The solution The CPI

• The idea is the following. We start by picking a
  base year. This is the year we will compare
  prices from all other years to.
• Then we think about all the different aspects of
  the cost of living for an average household
  housing, food, clothing etc. and we prepare a
  market basket consisting of specific items and
  their average costs.

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• Lets take a few examples and see how to
  construct an index
• Item Base Year Next Year
• Rent 500 550
• Gallon gas 1.11 1.06
• The index for the categories
• Rent 550/500100 110
• Gasoline 1.06/1.11100 95.5

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• The CPI is constructed by finding the index of a
  variety of goods and weighting them according to
  the proportion they take up of the average
  household spending

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• Category Index Weighting
• Housing 110.0 39.6
• Transport. 95.5 17.6
• Food 101.4 16.3
• Entertainment 102.9 6.1
• Medical Care 101.3 5.6
• Education 91.7 5.5
• Apparel, upkeep 103.1 4.9
• Other 103.1 4.3

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• Now we take the weighted average of these
• 11039.695.517.6101.416.3102.96.1101.3
  5.691.75.5103.14.9103.14.3
• This yields 103.4

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The official CPI since 1982
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• The weird equation
• 1982-1984100
• means that they computed the price of the market
  basket using the average of the prices from
  1982-84 as base.
• So what does the CPI mean and what is it good
  for?
• BE CAREFUL! It does NOT give you the cost of the
  market basket in any given year.

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• The CORRECT interpretation
• Think of the index as telling you how much the
  average consumer has to spend in any given year
  to buy the same goods and services that she would
  have bought for 100 in the base year.

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• The next question is what is this good for?