The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by consumers for a basket of goods and services. It is used to track inflation, which is the rate at which the prices of those goods and services increase. The CPI is calculated by taking the cost of the basket of goods and services in a specific period (the “base period”) and comparing it to the cost of the same basket in a different period (the “current period”). The percentage change in the cost of the basket is then used to determine the rate of inflation.
The basket of goods and services included in the CPI is designed to be representative of the spending patterns of the typical household. It includes a wide range of items, such as food, housing, clothing, transportation, and medical care. The weight given to each item in the basket is based on the relative importance of that item in the average household’s budget.
CPI is widely used as a measure of inflation, and is also used in adjusting many financial and economic series for inflation. For example, wages, salary, and pensions are often adjusted using the CPI, as are taxes and other government fees. It also used to adjust index-linked bond and other financial contracts, and as a means to adjusting incomes and other cash flows for inflation.
There are several different versions of the CPI that are used in different countries and by different organizations. Some of the most common include the Consumer Price Index for All Urban Consumers (CPI-U), which is used by the Bureau of Labor Statistics (BLS) in the United States, and the Harmonised Index of Consumer Prices (HICP), which is used by the European Union (EU). These indexes use slightly different methodologies and include different baskets of goods and services, but they all aim to measure the same underlying concept: the rate of inflation faced by consumers.
One important aspect of the Consumer Price Index (CPI) is that it is based on a fixed basket of goods and services. This means that the basket of items included in the index is set at a specific point in time, and does not change over time. While this approach has the advantage of making it easy to compare inflation rates across different time periods, it also means that the index does not account for changes in the composition of the basket that might occur due to changes in consumer spending patterns.
Another limitation of the CPI is that it is based on a “Laspeyres” index, which measures the price change of a fixed basket of goods and services bought by a representative consumer in a given period compared to a base period. This method tends to overstate inflation because it assumes that consumers always buy the same basket of goods and services, and thus it doesn’t take into account the possible changes in consumption behavior due to price changes, (like substitution to cheaper products or services) that would reflect in reality.
There are alternative indexes such as Paasche index, that measures the price change of a basket of goods and services currently consumed by a representative consumer compared to a base period. It does not assume that the basket of goods and services is fixed, instead, it takes into account any changes in consumption behavior due to price changes.
Despite these limitations, the Consumer Price Index (CPI) remains a widely used and accepted measure of inflation, providing a benchmark that is used by governments, central banks, businesses, and individuals to make important economic decisions.« Back to Financial Terms Index