The Consumer Price Index, commonly known by its abbreviation CPI, is a calculated measure of the average price level in an economy. The CPI consists of a selected group of common goods and services. It measures any changes in the purchasing strength of a country’s currency and the current price of a group of goods and services.

The Consumer Price Index will reflect any changes in price of the market basket of goods and services that are consistently used by all people of all ages. It is normally computed monthly or quarterly, regularly enough to have an accurate visualization of the price of the market basket.

The market base that is used to compute and calculate the Consumer Price Index accurately represents the consumption expenditure within the economy and it is more simply, the central weighted average of the prices of commonly used goods and services.

DETERMINING THE MARKET BASKET

 A regulatory body collates the prices of goods and services over the course of the calculation period by regularly contacting retailers and service providers across the country. This information is then used to develop the market basket. A particular item will enter the basket through a process. Using bread as an example, a particular brand of bread is chosen with it’s probability of choice being directly proportional to its sales numbers.

This means that even if there are different types and brands of bread, the representative bread that will be chosen is the one that is most commonly purchased. The price of the representative bread is then monitored for the next four years after which a market survey is carried out to determine which bread is selling the most. The commodity with the highest purchase figures will represent all brands of that commodity in the market basket. All these commodities are then grouped together and added to produce the “Cost of the market basket”.

CALCULATING & COMPUTING THE CONSUMER PRICE INDEX

After governments have spent valuable time and resources to monitor product and service prices to determine the cost of the market basket, the consumer price index formula is then applied to determine the consumer price index. Now, for the CPI to be computed, there has to be a base year.

This base year is mostly selected by the highest financial/economic body of the country and is normally expected to be the year with the least recorded “cost of the market basket” in that economic era. The United States uses the 1982-1984 period. The base year will also have an index level. This means that year will also have its own “Cost of the market basket”.

If the index of the base year is 100 and a newly calculated index of the given year is 110, there’s been a CPI increase by 10% which also means there’s been a 10% rise in the price of the market basket. Similarly, if the index of the base year is 100 and the index of the given year is 90, that means there’s been a 10% decrease of the CPI which is also a 10% decline in the cost of the market basket.

The formula for calculating the index is the “Cost of the Market Basket in a given year ” divided by the ” Cost of the Market Basket in the Base Year” x 100%.

The Consumer Price Index is used as an economic indicator as it is an accurate measure of inflation faced by the user of the products measured on the market basket. It can also be used to measure the effect of government economic policies.

It is also used to adjust other economic indicators e.g. components of national income to price changes. It can also prevent an increase in tax rates due to inflation by providing information on the cost of living for dependent citizens.

However, the CPI is not without it’s limitations. The measurement process especially has it’s own problems which include risk of the right representative item not being chosen, non-inclusion of energy costs which are common in household expenditure and errors associated with the collection of price data among others.

The CPI’s may not also be applicable to all human groups e.g. the Urban and Rural difference in product quality is glaring and one product cannot be adequately used to represent both groups.

There are also no official estimates for population subgroups and social and environmental factors that contribute to the standard of living cannot be defined by the index. Two different areas might also have different prices in relation to the same product which means the CPI cannot adequately reflect the prices of the two areas using one.

The benefits outweigh the risks though which is why the Consumer Price Index is still very much used by economic bodies of many countries to make economic decisions.

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