1.6 Consumer Price Index

The last topic of this chapter is the Consumer Price Index (CPI)Consumer Price Index (CPI): The percentage change in the cost of a basket of goods today compared to some base year.. CPI is a measurement that is often discussed in financial markets because it is used to adjust for inflation. Simply put, CPI is the percentage change in the cost of a basket of goods today compared to some base year. CPI represents some fixed-expenditure weighted index used to measure changes in the purchasing power of households. One drawback of CPI is that it suffers substitution bias, so it oftentimes overstates the impact of price changes. Regardless, it is the preferred measure of purchasing power. Mathematically, we calculate CPI as

$CPI = \frac{{Cost of Goods}_{t}}{{Cost of Goods}_{t - n}}$ $CPI = \frac{{Cost of Goods}_{t}}{{Cost of Goods}_{t - n}}$

where the subscript t is the current year and t − n is some base year n periods in the past. If we wanted to calculate the CPI for 2020 and use 2015 as the base year, then we would use the cost of some basket of goods for both 2020 and 2015. A “basket of goods” might be all purchases in the U.S. economy, for example, or it might be just the food purchased in the U.S. economy. It can be any group of assets for which we are worried about inflation. Plugging the years into the equation above gives us

$CPI = \frac{{Cost of Goods}_{2020}}{{Cost of Goods}_{2015}}$ $CPI = \frac{{Cost of Goods}_{2020}}{{Cost of Goods}_{2015}}$

We can also use CPI to estimate an inflation rate relative to some base year. The equation we would use is

$Inflation Rate = \frac{{CPI}_{t} - {CPI}_{t - n}}{{CPI}_{t - n}}$ $Inflation Rate = \frac{{CPI}_{t} - {CPI}_{t - n}}{{CPI}_{t - n}}$

Using the same years as the previous example, if we wanted to see how much inflation an economy experienced from 2015 to 2020, we would simply plug the CPI for each of those years into the above equation as follows:

$Inflation Rate = \frac{{CPI}_{2020} - {CPI}_{2015}}{{CPI}_{2015}}$ $Inflation Rate = \frac{{CPI}_{2020} - {CPI}_{2015}}{{CPI}_{2015}}$

Each of these equations gives us the decimal representation of the change. If we wanted to convert the value to a percentage, we would simply multiply the output by 100.

Example of CPI

Consider the gas example from the previous section where the gallon of gas you want to purchase went from $3 to $4.50. If you wanted to compute the CPI for that basket of goods, you would use the CPI equation, which is

$CPI = \frac{Cost of Gas Now}{Cost of Gas Back Then} = \frac{$ 4.50}{$ 3.00} = 1.5$ $CPI = \frac{Cost of Gas Now}{Cost of Gas Back Then} = \frac{$ 4.50}{$ 3.00} = 1.5$

Example of Inflation Rate

Let’s say we had computed the CPI for the period before the jump in prices from $3 to $4.50, and it was 1.1. If we wanted to compute the inflation rate over the two different time periods, we would use the inflation rate equation, which equals

$\frac{1.5 - 1.1}{1.1} = 0.3636$ $\frac{1.5 - 1.1}{1.1} = 0.3636$

Multiplying this result by 100, we get 36.36%.

Key Terms Review

Barter economyBarter economy: An economy in which people trade goods and services.	Financial instrumentsFinancial instruments: A part of the financial system that provides access to financial markets, collects and processes information, and provides financial services.	Monetary policyMonetary policy: Actions by the Fed to manage inflation.
Central banksCentral banks: A part of the financial system that monitors and stabilizes the financial system.	Financial marketsFinancial markets: A part of the financial system that allows for the buying and selling of financial instruments.	MoneyMoney: An asset that serves as a means of payment, has a unit of account, and stores value.
Commodity moneyCommodity money: A type of money that has intrnisic value, such as precious metals.	IncomeIncome: The flow of earnings over time.	Money aggregatesMoney aggregates: Measures of assets in an economy.
Consumer Price Index (CPI)Consumer Price Index (CPI): The percentage change in the cost of a basket of goods today compared to some base year.	InflationInflation: The purchasing power of a specific currency at any given time period.	Net worthNet worth: The market value of assets minus the market value of liabilities; also called wealth.
CryptocurrencyCryptocurrency: A form of electronic money that relies on blockchain technology.	LiquidityLiquidity: The ability to convert an asset into a means of payment without losing significant value.	Regulatory agenciesRegulatory agencies: A part of the financial system that ensures that elements of the financial system operate safely and reliably.
Federal Reserve SystemFederal Reserve System: The central bank of the United States.	M1M1: A money aggregate estimated using only the most liquid assets in the economy.	Store valueStore value: A characteristic of money such that it is durable and capable of transferring purchasing power from one day to the next.
Fiat moneyFiat money: A type of money whose value is printed on a bill or coin and guaranteed by a government.	M2M2: A money aggregate that includes assets that are not necessarily considered liquid or used as a means of payment.	The FedThe Fed: Short for Federal Reserve System.
Financial institutionsFinancial institutions: A part of the financial system that provides access to financial markets, collects and processes information, and provides financial services.	Means of paymentMeans of payment: A characteristic of money such that it can be used to finalize any exchange between two people.	Unit of accountUnit of account: A characteristic of money such that it holds some standard value used to quote prices.
		WealthWealth: The market value of assets minus the market value of liabilities; also called net worth.

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