The consumer price index is a weighted index used to measures the changes in consumer pieces in an economy. This used to observe the changes in the real value of money as a result of the inflationary situation. This is also taken as a macroeconomic tool that indicates the performance of the economy because the changes in the consumer price index affect the functioning of the whole economy. The importance of the consumer price index depends on the accuracy of its computation. Several arbitrary decisions have to be made when calculating the price index.
First thing is to select a base year that there is no chronic inflationary situation or economic recession. It should be a year of economic stability. The consumer price index in the base year is considered 100. This is considered as a reference point from where the prices of goods and services change. It should not be a year far back which is difficult to compare the price changes.
Secondly, the basket of goods of which the price changes are observed should be selected. These should be the items that are important in consumer spending and once selected, they should represent all the other goods that are consumed by all the consumers of the economy. Goods are included in the basket of goods by getting sales information through market surveys. Goods included in the basket are given weights according to their importance. The price collected is multiplied by the weights given to find the price changes as an index. The following formula is used to calculate the Consumer Price Index.
As per the above table, the price of rice has increased from Rs.50 to Rs.75, showing a 25% increase compared to the base year 100. Then the respective weight is given by multiplying it by the respective weight. To find the current year’s PI, the sum of weighted indices is divided by the sum of weights. The consumer price index which was considered as 100 has increased to 155. It shows that the prices in the economy have increased by 55% compared to the base year.
The magnitude of price increase is calculated as the rate of inflation. The rate of inflation is the percentage increase in the consumer price index between two consecutive years. The rate of inflation is used to identify the rate at which the value of money has changed within a year.
Different economists such as Laspeyre, Paarche, have attempted to calculate the change in consumer prices by using different formulae with some modifications.
- Pi, O is the price of the individual item at the base period, and Pi,t is the price of the individual item at the observation period.
- Qi, O is the quantity of the individual item at the base period.
One of the advantages of this commonly used formula is that it is easy to calculate. Only the current and the base year’s individual prices and the quantities are needed.
Though the CPI is widely used to measure economic performance, there are some common problems that affect accuracy and credibility. The basket of goods selected may not represent the goods consumed by all the consumers. People of different social classes have different consumption patterns which may not be highlighted in the sample of a basket of goods. In addition, the consumption pattern changes over time and regular updating does not happen.
Difficulty in getting accurate consumption details also affects the efficiency of CPI. Typical consumers hesitate to reveal them thinking that it will harm their privacy. In addition, the quality of the products is not considered when observing the price changes.
However, the CPI is used to measure the rate of inflation.