Measuring Inflation (Cambridge International A-Level Economics)

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'

$\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{year}X}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100$

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

Worked Example Using the information in the table, calculate the inflation rate for 2021 if the price of the basket in the base year (2019) was $400 **[3]

Good	Price 2020	Price 2021	Weight	Basket 2020 (Price x weight)	Basket 2021 (Price x weight)
Housing, water, electricity, gas	950	1200	34%	323.00	408.00
Transport	250	325	11%	27.50	35.75
Food	500	620	9%	45.00	55.80
Recreation and culture	300	340	10%	30.00	34.00
Clothing and footwear	190	210	5%	9.50	10.50
** **				$435.00	**$544.05

Answer:

Step 1: Calculate the CPI for 2020

$\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in}2020}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100\,\,=\frac{435}{400}x100\,\,=108.75\,$

Step 2: Calculate the CPI for 2021

$\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in}2021}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100\,\,=\frac{544.05}{400}x100\,\,=136.01$

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

$\text{Inflation} \text{rate} = \frac{New \text{CPI} - \text{Old} CPI}{Old CPI} \mathrm{x} 100

= \frac{136.01 - 108.75}{108.75} \mathrm{x} 100

= 25.07 %$

(3 marks for the correct answer or 1 mark for any correct working. Answers should be rounded to 2 decimal places to be correct)

Note on method

The same inflation rate can be calculated directly from the basket costs without first converting to a CPI index:

$\text{CPI} = \frac{( \text{basket} \text{cost} \text{in} \text{current} \text{year} - \text{basket} \text{cost} \text{in} \text{previous} \text{year} )}{435.00} \mathrm{x} 100

= \frac{544.05 - 435}{435} \mathrm{x} 100

= 25.07 % $

Both methods give the same answer. CIE may present the question either way - if basket costs are given directly, the direct comparison method is quicker. If a price index is given, use the CPI percentage change method. Always check which data you have been given before choosing your approach.

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

Exam Hint The strongest evaluative point on consequences is the redistribution effect - inflation transfers real wealth from creditors to debtors because the real value of debt falls as prices rise.

Always consider who gains and who loses rather than treating inflation as uniformly harmful.