Understanding and Calculating CPI

Understanding and Calculating CPI

CPI stands for Consumer Price Index and it is a measure of the average price changes in a defined basket of goods and services that are commonly used by people. Generally, the CPI is used as an indicator of the cost of living as well as the economic growth of a nation. Along with the GDP deflator, the CPI is used as a measure of inflation. It allows economists and policymakers to gauge the economic performance of a nation and thereby guide macroeconomic policies.

Here is guidance on how to calculate CPI.

Defining the Basket

As the first step in addressing the question, how to calculate CPI, we need to know what’s in the market basket. The goods and services that are purchased for consumption by a market’s population are included in the CPI market basket. In order to fix a market basket, we need to understand the number of households present in a nation along with the quantum of consumption across these households. A lot of surveys and census needs to be used in defining this data and thereby arriving at a market basket. 

Calculating Cost of Market Basket

Once we know what all gets included in the basket and their quantities, we need to calculate the current as well as previous prices of these goods and services. This gives us an idea of the price of the basket at any point in time. Since the market basket remains fixed in terms of items and the quantities, the only variable here is the price. This allows us to isolate the price change effects over the years. 

Index Calculation

In order to calculate CPI, we need to define a base year. This will serve as a benchmark and we can easily compare all the other years against this benchmark. Generally, the base year is kept the same for a few years until it is changed to a new one. CPI is calculated by dividing the price of the basket in any given year by the price of the basket in the base year. The ratio is then multiplied by 100 in order to get CPI value.

Inflation Rate

It is not enough to only calculate CPI. We need to use CPI figures in order to determine the inflation rate, thereby meeting the economic need of CPI. The inflation rate is nothing but the percentage change in CPI from one time period to another. Inflation rates across nations are measured using CPI and are also published from time to time.

The prices that are paid by consumers for purchasing goods and services are used in calculating CPI and this, in turn, is used to understand the inflation levels. It helps in understanding the cost of living levels of a nation. Cost of living can affect people in various ways. CPI is simply the cost of living put in numerical form. While there is a lot of debate on the importance of and how to calculate CPI as a measure for inflation, it still has widespread use when it comes to controlling inflation and thereby guiding the movement of an economy.

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