Inflation is measured using CPI.

The percentage change in this index

over a period of time gives the amount of inflation over that specific
period, i.e. the increase in prices of a representative basket of goods
consumed

Consumer Price Index

There is a huge difference in the consumption pattern of people in

society. Thus, to understand this pattern, we need to understand the
prices that are paid by these sections. The index numbers that we use
generally fail to depict the changes. Thus, we use the consumer price
index (CPI) to understand this pattern.

An average change in price by a specific type of customer is explained

by the consumer price index. Thus, it is done for the services and goods
that are consumed in the current year. CPI is also known as the cost of
living index. This is because when the price level changes, consumption
pattern also changes.

Thus, this change alters the cost of living. There are three groups for
CPI is measured. They are agricultural labors, Industrial workers, and
urban non-manual labors.

Significance of CPI

CPI depicts how the changes in price levels affect heterogeneous

customers. Also, it helps the government in formulating fiscal policies,
price policy, tax policy, etc.

Thus, it helps the government in calculating the risks taken for

development without changing the cost of living. Also, the state
government uses CPI to decide the wage structure. Additionally, this
helps them to construct the dearness allowance of the workers.

Also, CPI is a measure of how accurate the power of a currency is. This
is based on the fact that any change in price triggers consumption.
Furthermore, national income is also calculated using the consumption
expenditure.

This is on the fact one’s expenses is another person’s income. Thus, CPI
acts as an income deflator nationally.

Limitations of CPI

Like index numbers, there are difficulties related to the CPI also. In a
vast country like India, different people have different standards of
living. Thus, one CPI cannot justify the entire diversity. Also, the price
indices used for CPI are done using retail prices.

However, retail prices vary from shop to shop and store to store. Thus,
the choice of retails price changes the entire result. So, the general retail
price needs to be chosen. Also, this should prevail in all the market.

The major difficulty that lies in is the change in consumption factor.

Thus, it means that there can also be variation in consumption among a
specific group of people.

Also, for an individual, the consumption ratio can vary to a large extent.
Thus, because of these reasons, the change in the cost of living is
questionable while calculating the CPI.

There are two methods used to calculate the CPI. They are a family
budget method and aggregative expenditure method.
CONSUMER PRICE INDEX:

Def: It measures the change in price of a fixed market basket of goods and services
from one period to another.
CPI an inflatory indicator that measures the change in the cost of a fixed basket of product and
services including housing, electricity, transport and food.

The CPI is computed through a four-step process:

1. The fixed basket of goods and services is defined. This requires figuring out where the
typical consumer spends his or her money. The Bureau of Labor Statistics surveys
consumers to gather this information.
2. The prices for every item in the fixed basket are found. Since the same basket of goods
and services is used across a number of time periods to determine changes in the CPI, the
price for every item in the fixed basket must be found for every point in time.

3. The cost of the fixed basket of goods and services must be calculated for each time
period. Like computing GDP, the cost of the fixed basket of goods and services is found
by multiplying the quantity of each item times its price.

4. A base year is chosen and the index is computed. The price of the fixed basket of goods
and services for each comparison year is then divided by the price of the fixed basket of
goods in the base year. The result is multiplied by 100 to give the relative level of the cost
of living between the base year and the comparison years.

EXAMPLE:
Let’s assume a country where consumers purchase only two vegetables carrot and capsicum.
According to the procedure defined above fix the basket of goods. A typical consumer purchases
2 kg carrots and 3 kg capsicum in a given period of time so fixed basket is 2 kg carrots and 3kg
capsicum. Second step is to find prices for each period of time. Third step is to compute basket
cost. The third step is to compute the basket's cost for each time period. In time period 1 the fixed
basket costs (2X $1) + (3 X $6) = $20. In time period 2 the fixed basket costs (2X $2) + (3 X $7)
= $25 in time period 3 the fixed basket costs (2 X $3) + (3 X $8) = $31. The fourth step is to
choose a base year and to compute the CPI. Since any year can serve as the base year, let's
choose time period 1. The CPI for time period 1 is ($20 / $20) X 100 = 100. The CPI for time
period 2 is ($25 / $20) X 100 =125.The CPI for time period 3 is ($31 / $20) X 100 = 155. Since
the price of the goods and services that comprise the fixed basket increased from time period 1 to
time period 3, the CPI also increased. This shows that the cost of living increased across this time
period.
Advantages and disadvantages of CPI:

Advantages:
The CPI influences the economy in several ways. A high annual percentage increase in the CPI
reflects a high rate of inflation. The CPI also determines the percentage of annual increase or
decrease in income. The federal government also uses the CPI to adjust Social Security and
disability benefits, to determine the income level at which people become eligible for assistance,
and to establish tax brackets. In addition, the CPI is often used to compare prices for certain
goods within a set of years, and to calculate constant currency values for two points in time.

Disadvantages:
It changes over time (consumer goods in the 1970s are not the same as they are in the 1990s).It
overstates inflation, because it fails to account for improvements in technology. The third problem
with the CPI is that changes in the quality of goods and services are not well handled. When an
item in the fixed basket of goods is used to compute the CPI increases or decreases in quality, the
value and desirability of the item changes.

Laspeyres price index:

Etienne Laspeyres developed a method in the latter part of the 18th century to measure a weighted
price index. An index calculated with Laspeyres price index formula measures price changes in
relation to the base period’s market basket and thereby fixes the market basket by holding the
items in it constant. It calculates what the market basket will cost in the later periods, even if some
of the items were no longer purchased.

It is calculated as follows:

Advantages and disadvantages:

Advantages: This is a statistical device used to measure changes in index numbers over a period
of time. The Laspeyres index measures the change in an identical 'basket' of (for example) goods
and services over a period. In inflation measures, for example, the prices of staple foods might be
considered to be more important in consumer spending patterns than a box of matches. Changes
in the price of those items, which feature heavily in everyday spending, therefore can be more
accurately reflected in the resulting index. The Laspeyres index uses weights determined in the
base year.
Disadvantages: Laspeyres price index tends to overstate inflation. The index implicitly assumes
that whatever the price changes the quantities will remain the same. In terms of economics
theory, no substitution is allowed to take place. Even if goods become relatively more expensive,
it assumes that the same quantities are bought. As a result, this index tends to overstate inflation.
Paasche’s price index:
An index calculated with paasche index formula measures price changes for a market basket
containing for what customers are purchasing currently rather what they have purchased in the
previous period.
It can be calculated as follows:

Advantages and disadvantages:

Advantages: This index assumes that consumer taste and preferences change to maintain a
constant level of satisfaction and compare the cost of consumer’s current market basket with
what it would have cost to buy this basket goods and services in early period. for example,
video cassettes played a more important part in spending habits ten years ago than they do today.
They have now been superseded by the availability of DVDs. Weightings therefore have to be
changed periodically to reflect these changes. A Paasche index will take this into account every
year.
Disadvantages: Paasche price index tends to understate inflation. The effects of substitution
would mean that greater importance is placed on goods that are relatively cheaper now. As a
result, this index tends to understate price. The comparison between years is different because
the index reflects both changes in price and quantity. The index requires information on the
current quantities and this may be difficult or expensive to obtain.

Fisher’s ideal index:

The Fisher ideal index, proposed by Irving Fisher in 1922, gives good approximations to the
theoretical or “exact” cost-of-living index and is relatively simple to compute and use. The
geometric mean of Laspeyres and Paasche index numbers. Also known as ideal index number.
It can be computed as:

Advantaged

Advantages: Fisher’s equation seems to b theoretically ideal. Fisher ideal index has the ability to
accommodate the effects of substitutions, something the Laspeyres and Paache indexes do not
do. A major advantage of Fisher ideal index over other superlative indexes, is its “dual' property,
i.e. a Fisher Ideal price index implies a Fisher Ideal quantity index, and vice versa. In other
words, the product of a Fisher Ideal price index between two periods and a Fisher Ideal quantity
index between the same two periods is equal to the total change in value (measured in current
dollars) between those two periods.
Disadvantages:It is rarely used in practice because it has same problem as the paasche index.It
requires a new set of quantities be determined for each period.

Value index:

A value index measures changes in both the price and quantities involved. It shows the change in
the sales of goods in current prices compared to the sales of previous periods. Value index is the
ratio in percentages of the indicator of the current period and that of the reference period. Price
index is not used while calculating the value index.

Consumer Price Index Numbers

Consumer price index numbers measure the changes in the prices paid by
consumers for a special “basket” of goods and services during the current year as
compared to the base year. The basket of goods and services will contain items like
(1) Food (2) Rent (3) Clothing (4) Fuel and Lighting (5) Education (6) Miscellaneous
like cleaning, transport, newspapers, etc. Consumer price index numbers are also
called cost of living index numbers or retail price index numbers.

Construction of Consumer Price Index Numbers

The following steps are involved in the construction of consumer price index
numbers.

(1) Class of People

The first step in the construction of the consumer price index (CPI) is that the class
of people should be defined clearly. It should be decided whether the cost of living
index number is being prepared for industrial workers, or middle or lower class
salaried people living in a particular area. It is therefore necessary to specify the
class of people and locality where they reside.

(2) Family Budget Inquiry

The next step in the construction of a consumer price index number is that some
families should be selected randomly. These families provide information about the
cost of food, clothing, rent, miscellaneous, etc. The inquiry includes questions on
family size, income, the quality and quantity of resources consumed and the money
spent on them, and the weights are assigned in proportions to the expenditure on
different items.

(3) Price Data

The next step is to collect data on the retail prices of the selected commodities for
the current period and the base period when these prices should be obtained from
the shops situated in the locality for which the index numbers are prepared.

(4) Selection of Commodities

The next step is the selection of the commodities to be

included. We should select those commodities which
are most often used by that class of people.

Methods of Consumer Price Index Numbers

There are two methods to compute consumer price index numbers: (a) Aggregate
Expenditure Method (2) Family Budget Method
Aggregate Expenditure Method

In this method, the quantities of commodities consumed by the particular group in

the base year are estimated and these figures or their proportions are used as
weights. Then the total expenditure of each commodity for each year is calculated.
The price of the current year is multiplied by the quantity or weight of the base
year. These products are added. Similarly, for the base year the total expenditure of
each commodity is calculated by multiplying the quantity consumed by its price in
the base year. These products are also added. The total expenditure of the current
year is divided by the total expenditure of the base year and the resulting figure is
multiplied by 100100 to get the required index numbers. In this method, the
current period quantities are not used as weights because these quantities change
from year to year.
Pon=∑Pnqo∑Poqo×100Pon=∑Pnqo∑Poqo×100

Here,
PnPn Represent the price of the current year,
PoPo Represents the price of the base year and
qoqo Represents the quantities consumed in the base year.
Family Budget Method
In this method, the family budgets of a large number of people are carefully studied
and the aggregate expenditure of the average family for various items is estimated.
These values are used as weights. The current year’s prices are converted into price
relatives on the basis of the base year’s prices, and these price relatives are
multiplied by the respective values of the commodities in the base year. The total of
these products is divided by the sum of the weights and the resulting figure is the
required index numbers.
Pon=∑WI∑WPon=∑WI∑W

Here, I=PnP0×100I=PnP0×100 and W=Poqo

Example:
Construct the consumer price index number for 19881988 on the basis
of 19871987 from the following data using: (1) Aggregate Expenditure
Method (2) Family Budget Method.
Quantity Prices
Commodities consumed Unit
in 19871987 19871987 19881988
AA 6 quintal quintal 315.75315.75 316.00316.00
BB 6 quintal quintal 305.00305.00 308.00308.00
CC 1 quintal quintal 416.00416.00 419.00419.00
DD 6 quintal quintal 528.00528.00 610.00610.00
EE 4 kg kg 12.0012.00 11.5011.50
FF 1 quintal quintal 1020.001020.00 1015.001015.00
Solution:
(1) The consumer price index number of 19881988 by Aggregate Expenditure Method:
Unit Prices
 Quanti
ty
Consu
Commo 19871987 19881988
med P1qoP1qo PoqoPoqo
dities PoPo P1P1
198719
87
qoqo
6 quin 315.75315 316.00316
AA 18961896 1894.51894.5
quintal tal .75 .00
6 quin 305.00305 308.00308
BB 18481848 1830.01830.0
quintal tal .00 .00
1 quin 416.00416 419.00419
CC 419419 416.0416.0
quintal tal .00 .00
6 quin 528.00528 610.00610
DD 36603660 3168.03168.0
quintal tal .00 .00
EE 4 kg kg 12.0012.00 11.5011.50 4646 48.048.0
1 quin 1020.0010 1015.0010
FF 10151015 1020.01020.0
quintal tal 20.00 15.00

∑P1qo=8884 ∑Poqo=8376.5∑
∑P1qo=8884 Poqo=8376.5
The consumer price index number of 19881988 is
Pon=∑Pnqo∑Poqo×100=88848376.5×100=106.06Pon=∑Pnqo∑Poqo×100=8
8848376.5×100=106.06

(2) The consumer price index number of 19881988 by Family Budget Method:
Quant Prices
ity
Consu
Comm
med 1987198 1988198
W=PoqoW= I=P1Po×100 Product
odities
19871 7 8 Poqo I=P1Po×100 WIWI
987 PoPo P1P1
qoqo
66 qui 315.7531 316.0031 189601.56189601.
AA 1894.51894.5 100.08100.08
ntal 5.75 6.00 56
 66 qui 305.0030 308.0030 184793.40184793.
BB 1830.01830.0 100.98100.98
ntal 5.00 8.00 40
11 qui 416.0041 419.0041
CC 416.0416.0 100.72100.72 41899.5241899.52
ntal 6.00 9.00
66 qui 528.0052 610.0061 365999.04365999.
DD 3168.03168.0 115.53115.53
ntal 8.00 0.00 04
12.0012. 11.5011.
EE 44 kg 48.048.0 95.8395.83 4599.844599.84
00 50
11 qui 1020.001 1015.001 101500.20101500.
FF 1020.01020.0 99.5199.51
ntal 020.00 015.00 20

∑W=8376 ∑WI=888393.5
.5∑W=8376.5 6∑WI=888393.56
The consumer price index number of 19881988 is