Measuring Inflation (Cambridge (CIE) A Level Economics): Revision Note

The consumer price index (CPI)

• Inflation is the sustained increase in the average price level of goods and services in an economy

  • The average price level is measured by checking the prices of a 'basket' of goods and services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • Many economies have an inflation target of 2% per annum

    • Low inflation is better than no inflation, as it is a sign of economic growth

• The inflation rate is the change in average price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%
     

Constructing the consumer price index (CPI)

• A 'household basket' of goods and services that an average family would purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods/services exit the basket and new ones are added

  • The number of goods in the basket varies from country to country e.g. the UK has 700 'goods' in their basket and Singapore has 4,800

• Goods and services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weighting in the basket

• Each month, prices for these goods/services are gathered from many locations across the country

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

• The percentage difference in CPI between the two years is the inflation rate for the period

Possible difficulties in the measurement of the CPI

• The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket

  • Depending on what households buy, the level of inflation for each one can vary significantly

  • As an average, it also ignores regional differences in inflation e.g. London's inflation may be much higher than Manchester's inflation

• Substitution bias: when prices of goods in the basket rise, consumers switch to cheaper alternatives, but the fixed basket does not reflect this, overstating inflation.

• The CPI is one of several methods used by countries in determining inflation - another is the retail price index (RPI)

  • This can make comparisons between countries less meaningful as one may use the RPI and another the CPI

• The CPI does not capture the quality of the products in the basket

  • Product quality changes over time and so the comparison with different time periods is less useful

• The CPI only measures changes in consumption on an annual basis

  • Changes in consumption can occur more frequently and the index is always behind these changes

• The CPI is prone to errors in data collection

  • It is based on a survey that goes to thousands of households each year, yet it is still a small sample

  • The respondents have no incentive to fill in the survey carefully and accurately