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The Consumer Price Index estimates purchasing power by tracking the costs of a sample "market basket" that consists of over 650 products and services, including food, energy, shelter, apparel, transportation, medical care, utilities, and insurance.
The Consumer Price Index (CPI) is a statistical measure of changes across time in the prices of a basket of typical goods purchased by typical consumers.To update the CPI, each month the Bureau of Labor Statistics (BLS) samples prices of items in this representative market basket in nearly 100 different major markets.
The BLS also conducts annual surveys of the prices paid and spending patterns of thousands of households in over 1,000 marketing areas to calculate weights for the CPI's components. The components of the CPI are weighted to reflect relative importance. For example, if typical families spend twice as much on syrup as on oatmeal, the weight for syrup prices will be twice that of the weight for oatmeal prices. The base period is changed every few years because spending patterns change, which requires updating weights for various goods. For example, cellular phones were unknown 15 years ago. Their current popularity means that their prices should now be reflected in the CPI. In 1987, the BLS switched its base period from 1967 to the period 1982--1984. Figure 1 traces the history of average consumer prices as measured by the CPI since World War II.
Figure 1 The CPI from World War II through 1993
How the CPI Is Used The CPI is used to estimate changes in the purchasing power of money and as an escalator (cost-of-living adjustment) in some contracts calling for future payments. Unfortunately, problems are inherent in any economic index used to prescribe policy.
Moving from Nominal to Real Values
Most economic variables are presented in their current dollar, or nominal, values. Nominal or monetary values are the dollar amounts received or paid. Nominal values lose comparability over time unless adjusted for inflation or deflation. Real values are nominal values adjusted for changes in the price level. For example, suppose your nominal income this year is $20,000. How does its purchasing power compare with your $10,000 income of 10 years ago? Are you better off or worse off? If all prices also doubled, it would take twice as much money now to buy the goods you bought ten years ago and you would be no better off. The purchasing power of your real income (Yreal) is current income (Ycurrent ) adjusted for inflation or deflation according to the formula: [1]
Yreal = [Ycurrent] / [CPI / 100]. Using the preceding formula with a CPI of 200 for this year (the base index for 10 years ago is 100), your current real income is $10,000 ($20,000/2.00= $10,000). Table 1 illustrates this conversion process for U.S. per capita income during selected years since 1929.
Just as we have adjusted nominal income to account for changes in the price level, we can adjust other nominal variables to see how relative prices are changing. Deflating is the process of ensuring the comparability of nominal values by adjusting them for inflation. The general formula for deflating any variable is:
real value = nominal value in dollars . price level/100
For example, movie tickets rose from an average of $4 each in 1983 to an average of $6 in 1993. How much did real prices rise for movies? The CPI (based on 1983 prices) rose to 133. Thus, real 1993 movie prices were $6/1.33, or around $4.50 per ticket, after adjusting to the 1983 base. Similar calculations are used to deflate home prices, wages, or any other nominal variables.
A price index ideally estimates purchasing power lost per dollar of spending by typical people. But averages mean little if you are atypical. After all, which is more important to you - your own score on a test or other students’ average grades? You may fall far below the class average, or you may be the often despised individual who “busts the curve”. The CPI is a similar average, and so may either overstate or understate the amount of inflation experienced by any given individual.
Can you gain from inflation? Yes. Even if the prices’ of goods you like rise faster than inflation, you may gain if prices drop for the goods you buy most. For example, a pilot who toured the country in a personal jet could be clobbered by inflation propelled by higher fuel prices, while over the same period, a computer enthusiast gained from falling prices for computer hardware, software, and supplies. Inflation also affects people less to the extent that they easily substitute among goods for which nominal prices change at different rates. For example, if you find diet and regular sodas equally appealing, an increase in artificial sweetener prices damage you far less than fans of diet Coke.
CPI as an Income/Payment Escalator Many monetary payments are directly tied to the CPI. For example, if a union wage contract has an escalator clause, wages rise by roughly the same percentage that the CPI climbs. Escalator clauses that buffer purchasing power from inflation are included in union contracts covering roughly 8 million workers. Many pension plans, various transfer payment programs, and the income brackets in the U.S. income tax system are also closely linked to the CPI. However, as Focus 1 indicates, rigidly tying payments to the CPI may overcompensate for real inflation.
CPI as an Economic Indicator
Every president since George Washington has pledged policies to secure price level stability, but with mixed results. Average prices have fallen at times (e.g., 1865-1890 and 1929-1933), but, more often, we have experienced at least mild inflation. Since World War II, the price level has risen persistently, so typical Americans now pay more attention to the Consumer Price Index than in earlier periods, and it has become a yardstick for evaluating macroeconomic policy.
Problems with the CPI Estimating changes in consumer prices poses conceptual problems for the Bureau of Labor Statistics. How can the BLS adjust the CPI to accurately reflect changes in (a) consumption patterns, (b) the availability of new products, (c) new qualities in older goods, and (d) the prices of major assets such as homes, which some families bought earlier at lower prices, while others must pay higher current prices to buy now?
The CPI is thoroughly revised about once a decade. Between revisions, the fixed nature assumed for the "representative market basket" fails to reflect changes in typical buying patterns, reducing the CPI's accuracy. Inflation tends to be overstated because consumers purchase more goods whose prices rise most slowly and cut back on items where prices rise most rapidly. (See Focus 1.) For example, between 1972 and 1980, average energy prices rose 218 percent, but consumer outlays for energy only rose 140 percent. In an effort to keep pace with changing consumption patterns, the BLS now conducts annual Consumer Expenditure Surveys.
Changes in quality may also distort price indices. The CPI overstates inflation if the BLS ignores the fact that price hikes sometimes merely reflect quality improvements. Suppose, for example, that 1999 movies are superior to films released in 1998. If ticket prices rise primarily because higher quality costs more, then the CPI might erroneously "signal" inflation. Similarly, deteriorating quality may cause inflation to be understated. Inflation occurs even though money prices stay constant if, say, fast food becomes less tasty because soy beans are substituted for ground beef in burgers.
Direct measures of the value of quality changes are impossible, so the BLS uses an indirect method---it estimates the costs of quality changes. When figures are available, cost differentials between new and old features are treated as proxies for real values of quality changes. This poses severe problems. For example, do the costs of improving pollution control devices represent improved automobile quality? Or are we actually just buying cleaner air?
Another problem in measuring inflation is that some asset owners gain from higher prices. For example, if inflationary pressures boost both wages and housing prices, current homeowners with fixed mortgage payments would not write bigger checks for their housing services. After adjusting for inflation, their real mortgage payments fall. The BLS now uses rental values as the cost for shelter, as compared to its previous approach of measuring housing costs by average monthly payments on new home mortgages. This helps the CPI to more truly reflect inflation for American households. The CPI is the most reasonable estimate of changes in average consumer prices.
Is the CPI Biased as a Payment Escalator? If the CPI precisely doubles, do typical consumers "lose" unless their money incomes at least double? Contrary to most people's intuition, the answer is NO.
Not every price increases 5 percent if the CPI jumps 5 percent. Some monetary prices would rise faster, and some slower when weighted averages of prices rise 5 percent. Relative prices rise for goods for which money prices rise faster than average, but the relative price actually falls for any good for which the money price does not rise as fast as average. For example, if average prices rise 5 percent while monetary prices for color TVs go up only 1 percent, the relative cost of a TV has fallen roughly 4 percent (compared to the prices of most goods).
The law of demand is a key for predicting how people respond to such changes in relative prices. Consumers will buy less of goods for which prices rise faster than average (i.e., those with increased relative prices), and more of goods for which monetary prices fail to keep pace with the CPI (i.e., those whose relative prices have fallen). But how do consumer responses to such changes in relative prices affect the CPI's accuracy as a payment escalator?
An increase in monetary income precisely equaling the CPI would ensure that typical consumers could buy exactly the same bundles of goods as they purchased prior to the increase in the price level. But would they? No. The new set of relative prices would guide them to select different bundles which these individuals must prefer to the old (still affordable) ones they would now forgo. Ergo, typical consumers would gain more satisfaction---and thus, subjectively, more "real" income---if each rise in the CPI triggered precisely proportional escalation of their monetary incomes.
The lesson here is that payment escalation exactly equal to the percentage change in the CPI more than offsets any losses from inflation. The payees would gain. But escalator clauses are intended only to ensure payees no losses from inflation---they are not intended to systematically improve the lot of typical payees. In recognition of these consumer adjustments, most escalator clauses are now activated only with a lag to offset this potential gain, or they are some fixed proportion of the CPI change, e.g., 80 percent.
Congress has begun adjusting the CPI downwards as a cost-of-living escalator for Social Security and other federal transfer payments. However, income tax rate structures use the unadjusted CPI to "escalate" the income brackets to which specific tax rates apply.[2] Thus, most taxpayers now gain from inflation because effective real tax rates are reduced when adjustments for a changed CPI are made.
Other Price Indices [1] Y is the standard macroeconomics notation for national income.
[2] Recall that U.S. income taxes are somewhat progressive---a higher income activates higher marginal tax rates on incremental income.
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