Measuring Inflation
Measuring Inflation
Inflation refers to an increase in the overall level of prices in an economy, Because inflation has economic costs and also represents changes in the cost of living for households and costs of production for businesses, it's important to be able to measure inflation properly.
There are a number of different ways to measure inflation. One option is to look at the prices of everything produced in an economy (weighted by how much of each of those things is produced), which results in what is known as the GDP deflator.
Another option is to survey a sample of producers in order to measure producers get for their output, which results in the Producer Price Index. However, because one of the purposes of measuring inflation is to understand changes in the cost of living for households, inflation is usually measured using the Consumer Price Index, which measures the prices that consumers pay for a range of typical household goods and services.
The Consumer Price Index
The Consumer Price Index (CPI) is based upon a hypothetical "basket" of goods and services that households buy. (Note that items in this basket can be purchased from either domestic or foreign companies, which is one way in which the Consumer Price Index differs from the GDP deflator and Producer Price Index.)
In a very simple economy, for example, a consumption basket for the purposes of the CPI might purchase 3 loaves of bread, 5 gallons of gasoline, and 4 movie tickets.
The CPI in any given year would then be calculated by taking 3 times the price of bread plus 5 times the price of a gallon of gasoline plus 4 times the price of a movie ticket.
Rather than using the raw price totals, however, the CPI is indexed to a value of 100 for a year that is determined to be a "base year."
Inflation is a measure of price changes over time, and these price levels are most often measured using the Consumer Price Index. Therefore, the inflation rate that is reported by the Bureau of Labor Statistics is equal to the percent change in the Consumer Price Index.
For example, if the CPI for year 1 is 100 (most likely because year 1 was designated the base year) and the CPI for year 2 is 107, then the annual rate of inflation is equal to (107-100)/100 x 100% = 7 percent.
Inflation doesn't have to be measured over the course of a year and can instead be calculated quarterly, monthly, etc. using corresponding data for the Consumer Price Index. (From a practical standpoint, it's difficult to calculate inflation over periods of time shorter than a month because CPI data is calculated monthly by the Bureau of Labor Statistics.)
The purpose of the Consumer Price Index makes it necessary to evaluate how well the CPI measures changes in a typical household's cost of living. There are two main challenges to the CPI in this regard:
First, the Consumer Price Index doesn't account perfectly for changes in product quality. For example, an average computer today might cost about the same as an an average computer cost last year, but today's computer is better than last year's computer in a number of ways that the CPI doesn't account for.
Similarly, the invention of new goods poses a challenge to the Consumer Price Index, since incorporating such goods into the basket while maintaining comparability over time can get quite tricky.
Second, the Consumer Price Index assumes that a household purchases the same basket of goods regardless of how the prices of those goods changes. In reality, however, households are probably smarter than this, and they likely substitute away from items that get disproportionately expensive to goods that got comparatively less expensive.
Both the inability of the CPI to incorporate technological progress and its failure to account for substitution in consumption decisions imply that, in most cases, the Consumer Price Index likely overstates increases in the cost of living that households actually feel.
Inflation refers to an increase in the overall level of prices in an economy, Because inflation has economic costs and also represents changes in the cost of living for households and costs of production for businesses, it's important to be able to measure inflation properly.
There are a number of different ways to measure inflation. One option is to look at the prices of everything produced in an economy (weighted by how much of each of those things is produced), which results in what is known as the GDP deflator.
Another option is to survey a sample of producers in order to measure producers get for their output, which results in the Producer Price Index. However, because one of the purposes of measuring inflation is to understand changes in the cost of living for households, inflation is usually measured using the Consumer Price Index, which measures the prices that consumers pay for a range of typical household goods and services.
The Consumer Price Index
The Consumer Price Index (CPI) is based upon a hypothetical "basket" of goods and services that households buy. (Note that items in this basket can be purchased from either domestic or foreign companies, which is one way in which the Consumer Price Index differs from the GDP deflator and Producer Price Index.)
In a very simple economy, for example, a consumption basket for the purposes of the CPI might purchase 3 loaves of bread, 5 gallons of gasoline, and 4 movie tickets.
The CPI in any given year would then be calculated by taking 3 times the price of bread plus 5 times the price of a gallon of gasoline plus 4 times the price of a movie ticket.
Rather than using the raw price totals, however, the CPI is indexed to a value of 100 for a year that is determined to be a "base year."
Inflation is a measure of price changes over time, and these price levels are most often measured using the Consumer Price Index. Therefore, the inflation rate that is reported by the Bureau of Labor Statistics is equal to the percent change in the Consumer Price Index.
For example, if the CPI for year 1 is 100 (most likely because year 1 was designated the base year) and the CPI for year 2 is 107, then the annual rate of inflation is equal to (107-100)/100 x 100% = 7 percent.
Inflation doesn't have to be measured over the course of a year and can instead be calculated quarterly, monthly, etc. using corresponding data for the Consumer Price Index. (From a practical standpoint, it's difficult to calculate inflation over periods of time shorter than a month because CPI data is calculated monthly by the Bureau of Labor Statistics.)
The purpose of the Consumer Price Index makes it necessary to evaluate how well the CPI measures changes in a typical household's cost of living. There are two main challenges to the CPI in this regard:
First, the Consumer Price Index doesn't account perfectly for changes in product quality. For example, an average computer today might cost about the same as an an average computer cost last year, but today's computer is better than last year's computer in a number of ways that the CPI doesn't account for.
Similarly, the invention of new goods poses a challenge to the Consumer Price Index, since incorporating such goods into the basket while maintaining comparability over time can get quite tricky.
Second, the Consumer Price Index assumes that a household purchases the same basket of goods regardless of how the prices of those goods changes. In reality, however, households are probably smarter than this, and they likely substitute away from items that get disproportionately expensive to goods that got comparatively less expensive.
Both the inability of the CPI to incorporate technological progress and its failure to account for substitution in consumption decisions imply that, in most cases, the Consumer Price Index likely overstates increases in the cost of living that households actually feel.
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