Consumer price index

The Consumer Price Index, or (CPI), is a metric used by economists to determine changes in the cost of living for the average consumer. There are other indexes used to determine or measure price fluctuations, such as the Employment Cost Index, Producer Price Index, etc., however, most people are concerned with the CPI. In general, Austrians tend not to rely on the CPI both for methodological reasons and inherent problems with how the CPI is constructed or interpreted.

How to calculate the CPI

There are essentially four steps to calculate the CPI.

1. Determine which items to place in the basket;
2. Purchase the basket;
3. Purchase the basket at some point in the future, e.g. one month, one year, etc.;
4. Compare the two numbers (total prices of each basket).

Note: the basket is a collection of regularly purchased consumer items such as food, housing, clothing, and transportation related items.

Problems Gauging Inflation

In general, economists, politicians, and members of the news media tend to understand inflation as a price phenomenon, rather than one related to monetary policy. Because of this, great attention is given to the CPI. However, Austrians understand that the CPI is merely a statistic; and a poor one at best.. Below are some of the problems with the CPI.

One issue is that the CPI often has a substitution bias. A basket of goods is fixed with a certain quantity of items, and their prices don’t necessarily grow in step with one another; some will grow or shrink faster than others. When the price of one item outpaces its substitutes, as in the hypothetical case of wheat and rice, consumers tend to shift towards the cheaper item, all else being equal. So, if the cost of wheat grows significantly higher than rice, consumers will increase the quantity of rice they buy in lieu of wheat. However, because the quantity of wheat purchased is static in the basket, it is assumed that the grain is still purchased in the same quantity, which artificially elevates the CPI.

The introduction of new goods can also distort the CPI. This is best understood in terms of the quantity of goods relative to the quantity of currency units. When the number of goods increases, the currency can purchase more of those goods, causing its value to rise. Because the CPI’s basket is fixed, just as above, these new goods are not counted, and therefore do not reflect the true value of the currency, once again overstating inflation.

Another factor which is not accurately reflected by the CPI is unmeasured changes in quality. When the producers of a good improve its function, add features, or otherwise make it more attractive to consumers, the currency’s purchasing power increases, because more value can be exchanged per unit. When a basket of goods is fixed with models from say, the year 2000, all of the innovation between then and now is not accounted for, and the real value is thus not shown. Just as above, this would tend to overstate inflation.

Links

• Consumer Price Index FAQ U.S. Bureau of Labor Statistics website
• CPI Unchained by Matthew Yglesias, December 2012
• What a new inflation measure would mean for your wallet by Annalyn Kurtz, December 2012
• Consumer price index at Wikipedia