Learn the consumer price index definition and understand how to calculate consumer price index correctly. Study cost of living vs. inflation examples. Updated: 11/21/2023
Consumer Price Index | Definition, Example & Calculation
Table of Contents
- Consumer Price Index: Definition
- Consumer Price Index: Example
- Cost of Living vs. Inflation
- Real Terms vs. Nominal Terms
- Lesson Summary
Frequently Asked Questions
Is the Consumer Price Index a good measure of inflation?
The Consumer Price Index is a decent measure of inflation because it looks at goods and services from different sectors of the country. It can be slightly deceiving because there can be a large variation in geographical inflation.
What is the Consumer Price Index and why is it important?
The Consumer Price Index is a measurement of a basket of consumer goods and services from different sectors of the market and their average price over a period of time. It's important because it can help to determine the rate of inflation across the economy.
What items are included in the Consumer Price Index?
Items that are included in the Consumer Price Index are food, housing, transportation, clothing, medical care, recreation and other goods. They are combined to form a basket of goods to measure.
Table of Contents
- Consumer Price Index: Definition
- Consumer Price Index: Example
- Cost of Living vs. Inflation
- Real Terms vs. Nominal Terms
- Lesson Summary
Shopping for groceries is something that most people do on a regular basis. If prices change slightly each time they shop, they are usually so small that the consumer hardly notices. But, most people experience needing to buy a certain item that they haven't bought in years and being shocked by the price. This rising and falling of prices across the market is continually measured by economists, who try to evaluate whether the overall trends are rising or falling. So, what exactly is the Consumer Price Index?
The Consumer Price Index definition is a measurement of a selection of consumer goods and services from different sectors of the market and their average price over a period of time. Consumer Price Index, also referred to as CPI, aims to see whether prices across the economy are rising or falling. Rising overall prices are known as inflation, and if overall average prices are falling, it's known as deflation.
Consumer Price Index is used for a few different reasons. The main reason for the CPI is to assess inflation and try to warn economists, businesses, and politicians when prices are rising too fast. CPI is also used to measure the cost of living in the economy. The cost of living looks at how far people's salaries will take them based on the prices of consumer goods in a specific geographic location. If prices rise quickly, but incomes stay flat, then the cost of living increases. A higher cost of living means that a person's salary doesn't cover as much of their needs as it used to.
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When the CPI is measured, it doesn't just look at specific goods. It looks at a large selection of goods and service industries and puts them all together. The bundle of goods and services that is measured is often referred to as a basket of goods and services. The following is an example of some different goods and services that might be included in a basket'.'
- Food Products - Food products include all types of food, like grocery store food, fast food, full service meals, quick service, and pre-packed foods.
- Housing - Housing consists of many of the expenses of living, like rent, mortgage payments, home energy, furniture, and appliances.
- Clothes - Clothing consists of basically anything that is worn on the body that isn't electronic. This includes jewelry and accessories.
- Transportation - Transportation is anything directly related to the transportation industry and includes car prices, plane fares, public transportation, and fuel.
- Medical Care - Any services or products that are associated with a person's medical care with regards to seeing a professional are considered medical care. This includes doctor visits, hospital stays, surgery, prescription drugs, and eye glasses.
- Recreation - Recreational goods and services include a variety of products that are used for fun. Televisions, bikes, kayaks, concert tickets, sporting events, and electronics that are not used for business are some examples.
- Education and Communication - If a product or service is used to educate or communicate, then it falls into this category. Shipping costs, cell phone plans, tuition, communication software, and even postage stamps fall into this basket.
- Other Goods and Services - This category is a huge batch of goods and services that don't fit easily in the previous categories. Haircuts, nail services, alcohol, wedding related services, and funeral expenses are a few examples.
How to Calculate Consumer Price Index
One of the most difficult aspects of determining the Consumer Price Index with regards to cost of living is the fact that the prices of goods and services vary so much from place to place. Rent is a perfect example of a measure of CPI that varies. Rent in central Florida will be much lower than rent in New York City, so how can they be compared? The answer is that only Americans who are considered to be living and working in urban areas are included. So, consumers that live in rural areas are not included in the Index. While there are still differences in cities, they tend to be closer in costs of living.
Not only does the CPI leave out rural consumers, but it doesn't include all cities, either. The primary Index focuses on the metropolitan areas of Chicago, New York, and Los Angeles. These three cities have a monthly CPI reported. There are an additional 11 cities that are reported bi-monthly, including Boston, Miami, and Dallas.
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After information has been collected, measuring CPI is a fairly simple process. The basket of goods and services is determined and then measured against the baseline of the same basket. The base year is chosen by the CPI, divided by the current year, and multiplied by 100.
{eq}CPI = (Base Year Basket / Current Basket) x 100 {/eq}
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There is a big difference between inflation and cost of living. Inflation is the measurement of the rise in prices across the country. The cost of living measures the cost it takes to maintain a level of living in a given geographical area.
Inflation is more universal across the country and focuses on the percentage rise in the price of goods and services as an overall, national economy. The data is used to compare the entire country's current economy with a baseline year. Cost of living is used to compare different places with one another. So, the cost of living in Miami would be used to compare it to the cost of living in Boston. Let's look at a snapshot of the difference before diving into each one.
- Inflation - The baseline year is 2016 and the current year is 2021. The inflation rate is 15.8%, indicating a 15.8% increase in prices over the 4 years.
- Cost of Living - The cost of living uses the information on prices of good and services, only it focuses on geographical location. A person making $50,000 a year can use the Cost of Living Index to see what that salary would be worth in different places across the U.S.
Cost of Living Index: Formula
The Cost of Living Index is the comparison of one geographical location's cost of living against another. Just like the CPI measures prices across the country, the Cost of Living Index uses the data that is gathered by CPI to create a scaled index. Essentially, it gives each location a score and assigns the score of 100 as the mean. But, what does that do for a consumer, and how can the scores be used?
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First, the goal is to understand what it costs in a geographical location to maintain the same quality of life. Let's assume that a single person living in Virginia makes $75,000 a year. Virginia scores just a few tenths of a percent above the mean of 100, so it can be used as a baseline. Now, if the person wanted to move to the New England area, they would look at the Cost of Living Index for states in the area. The cost of living for the state of Massachusetts is 131.
The formula to use for determining the Cost of Living Index is to take the score difference between two locations and divide by 100. The formula looks like this:
{eq}Cost of Living = (Location B Score - Location A Score) / 100 {/eq}
{eq}Cost of Living = (131 - 100) / 100 = .31 {/eq}
Now that the Cost of Living Index of Massachusetts vs Virginia is identified as .31, the person making $75,000 a year knows they would have to make 31% more to maintain the same quality of life.
{eq}75,000 x .31 = 23,250 {/eq}
{eq}75,000 +23,250 = 98,250 {/eq}
So, in Massachusetts, the person from Virginia would have to make $98,250.
Inflation and Deflation
Inflation was mentioned in comparison to cost of living, but the term isn't quite as simple as a rise in the price of goods and services. As the economy moves forward, there is an expected rise in overall prices. Most older Americans will be more than willing to talk about how cheap gas used to be or how much a can of soda cost in their day. But, what those stories don't usually include is that their income was also proportionately lower. People who travel internationally often see inflation first-hand with regards to exchange rates. Inflation and deflation are tied to the buying power of money. When inflation in the U.S. rises, the buying power of the U.S. dollar lowers and exchange rates get worse. A burger in Rome might cost $15 instead of $12, simply due to the exchange rate.
Inflation is the lowering of the buying power of consumers due to the cost of rising prices. If prices for goods and services rise by 2% along with incomes, then it's not considered inflation. True inflation occurs when prices rise sharply and incomes do not rise at the same rate. The result is a reduction of the monetary power a consumer has. The effect is that even though people's incomes remain the same, the amount they can buy is reduced. The grocery bill for a family of three might go from being $180 a week to $200. Let's take a look at an example.
- Bre is a nurse practitioner in Atlanta who earns $100,000 annually. If the prices of goods and services rise by 8% in a single year, but her salary remains the same, her buying power reduces to $92,000.
Inflation is generally caused by two factors. The first is the increase in the flow of money in the economic system. This means that lenders give more money to borrowers at lower interest rates. The second factor is when consumer demand outpaces production abilities. If consumers demand 100,000 items a month, but capacity can only allow production of 80,000, the prices are likely to rise. Following the worst of the 2020 COVID-19 pandemic, a period of inflation began because both of the causes were in play. Lending was at historic highs in order to help businesses and individuals stay afloat during the shutdowns. The shutdowns also caused a steep drop in production. So, there was a lot of money in the system, but few goods to purchase. In the 1970s, inflation was also very high following the Vietnam War and the gas crisis.
Deflation is the increase in the buying power of money due to a lowering of prices. Deflation is caused by the reduction on the supply of money that flows through an economy. This is usually caused directly by an increase in costs and requirements for lending. There are mixed opinions on the overall effects of deflation, but essentially, individuals and companies that have a larger supply of cash reserves or near-liquid assets are the best off because they can take advantage of lower prices without the need to borrow.
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Inflation and cost of living are important factors in understanding the Consumer Price Index. There are two other terms that help round out the concept and bring it to a close. Let's go back to Bre, the nurse practitioner from Atlanta. She makes a salary of $100,000 are year. If the prices of goods and service rise by 10%, she will still make $100,000 a year, but it won't go as far as it did before the price rise.
- Nominal Terms - Nominal is the term used to describe the monetary value of something before the adjustment for inflation or Cost of Living Index. Bre's salary of $100,000 dollars after 10% inflation is the nominal value of her income.
- Real Terms - Real is the term used to describe the actual value after taking inflation and cost of living into account. While Bre's salary is still $100,000 after 10% inflation, her real salary is only $90,000.
Calculating nominal vs real is as simple as subtracting the rate of inflation from the nominal rate. Let's assume that an investor's nominal rate of return on an investment over the course of a year was 12%. In the same year, inflation was 7%. The investor's real rate of return would be his nominal rate minus the inflation.
{eq}Real Rate = 12 - 7 {/eq}
{eq}Real Rate = 5% {/eq}
So, while the investor saw an actual 12% increase in their portfolio, the spending power dropped by 7%.
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The Consumer Price Index is the measurement of a basket of goods and services from different areas of the country. The Index measures the average current prices of the basket of goods and compares them to a baseline year. If the prices are higher, then there is inflation, and if the prices drop, there is deflation. The Consumer Price Index, also known as CPI, looks at industries like housing, food, clothing, transportation, medical care, recreation, and other services and goods.
Inflation is when the buying power of consumers is reduced across the country due to the prices of goods and services increasing. Cost of living is the measure of how much it costs to maintain a certain quality of life in a given geographical area. Cost of Living Index is a comparison between two areas and is expressed on a scale where 100 is the mean score. Inflation is caused either by the increase in the supply of money in the system or by the inability for production to meet demand. Sometimes, it can be caused by both at the same time. Deflation is the reduction in the price of goods and the increase in buying power. It is usually caused when lenders keep more money out of the system. Nominal terms or rates refer to the values identified before inflation is accounted for, and real terms or rates are the adjusted values based on inflation or deflation.
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Video Transcript
A Circular Flow of Money
In the economy, there is a circular flow of money, factors of production, and goods and services. For example, when Dave works for Mandy's Cake Walk as a cake decorator, he earns an income he can spend on goods and services. During the year, Dave spends his income on a wide variety of products and services. When Dave goes to the store, he takes $100 with him, and he buys a regular basket of items that he needs throughout the year. Let's say he buys eggs, milk, cereal, bread, a pound of ground beef, celery, and orange juice. He also buys gas for his car, pays a utility bill, and makes a monthly payment for shelter throughout the year. This year, Dave buys a used car, takes a vacation by airplane, and also goes to the doctor. All of these expenses are incorporated into the Consumer Price Index each year and measured across the entire economy.
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Why is this important? Because next year, when Dave goes to the store and spends the same $100, he notices that his $100 does not buy the same amount of stuff. This is because the prices of goods and services tend to go up over time. Dave's cost of living has increased, not only when he goes to the store, but also when it costs more to fill up his gas tank and when it costs more to take a vacation. Inflation is one of the most important concepts you can possibly understand in macroeconomics, and it affects each and every one of us.
Why Do Prices Rise?
Why do prices rise? One reason is changes in supply and demand. For example, when demand for products and services increases, suppliers will raise their prices in response. Likewise, when the Organization of Petroleum Exporting Countries (OPEC) decides to reduce the supply of oil, then, if nothing else changes, the price of oil (and therefore gasoline) will rise. Another reason that prices tend to rise is because the supply of money in an economy increases. This makes the value of each dollar less. The effect of a falling dollar is rising prices.
Following the worst of the COVID-19 pandemic, a period of inflation began because both of the causes were in play. Lending was at historic highs in order to help businesses and individuals stay afloat during the shutdowns. The shutdowns also caused a steep drop in production. So, there was a lot of money in the system, but few goods to purchase. The higher inflation continued for several years as governments attempted to lower it by imposing higher interest rates and lower economic subsidies.
Inflation and Deflation
Let's take a look at inflation through the eyes of an economist using terms that describe what's happening with the level of prices and also what's happening with the value of the money that consumers spend throughout the year. Inflation is a sustained increase in the average level of prices in the economy. The opposite of inflation is deflation, which is a sustained decrease in the level of prices in an economy. The inflation rate is the rate at which prices are increasing, usually on an annual basis. The inflation rate is a widely watched report released by the Bureau of Labor Statistics. In the 1970s, the U.S. experienced a dramatic increase in the rate of inflation that led to a major economic challenge, especially for business owners, who encountered extremely high rates on bank loans.
Consumer Price Index
Economists measure inflation, or changes in the level of prices, using a price index. The Consumer Price Index is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation in an economy. The Consumer Price Index reveals to us the capacity of our money to buy goods and services, which we call purchasing power. Purchasing power represents the amount of goods and services that $1 will buy. When prices go up that means the purchasing power of money has gone down.
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Here's an example. An index is a number that starts at 100 in a certain year, which we call the base year. It changes over time in comparison with the base year and can be easily converted into a percentage since the base year starts at 100. For example, if the Consumer Price Index is said to start at 100 in the year 2022 and then the index increases to 103 in 2023, we can quickly calculate that prices in our economy have risen by 3 divided by 100, which is 3%. That means the inflation rate is 3% and that $1 will buy 3% fewer goods and services than it did at the end of the previous year.
An additional difficulty is determining how much of a price change is due to inflation, and how much is due to an increase in quality. For example, if a safety feature costing $200 is added to all new autos but overall new auto prices rise by $450, only $250 of that increase is actually due to inflation. This requires truly informed analysis.
Real Terms vs. Nominal Terms
Economic statistics are numbers that describe changes in the economy. They can be presented in two different ways - either as an original number or as a number that is adjusted for the cost of living, or inflation, which measures changes in the price level. Statistics that are presented to us in nominal terms show us the actual numbers before adjusting for changes in the level of prices. Statistics presented in real terms, however, show us numbers that already reflect changes in the price level and are, therefore, after inflation. Because of this adjustment, real data show us what something is worth in terms of its real purchasing power.
Here's an example: your neighbor, Bob, owns a lawn service. Bob's nominal income rises by 3% this year; the inflation rate, however, is 4%. What does that mean? That means that prices in the economy rose by more than Bob's income did. When he goes to spend his income, he'll find that he can't buy the same amount of goods and services that he could last year, even though in dollar terms his income went up. The formula for calculating this change of income in real terms is real = nominal minus inflation. This is when you're dealing with percentages. This formula works for any type of increase, whether it's income or interest rates, or GDP. So, in this example, Bob's real change in income is equal to his nominal change minus the rate of inflation, which would be 3% minus 4% = -1%. His real change in income was -1%.
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Looking at this scenario a different way, if Bob's nominal income rises by 3%, while his real income fell by 1%, then that means that prices in the economy rose by 4%. We can calculate this number by subtracting -1% from 3%, which give us 3% minus - 1% = 4%. We're just moving that formula around.
Let's look at one more example using interest rates instead of income. When the nominal interest rate on a bank checking account is 1% and the rate of inflation is 2%, the real interest rate would be 1% minus 2%, which would be -1%.
Lesson Summary
To summarize what we've talked about in this lesson, inflation is a sustained increase in the price level. The inflation rate is the rate at which inflation is changing, usually reported on an annual basis. The inflation rate is taken from The Consumer Price Index. The Consumer Price Index is an index measuring changes in the level of prices in the economy. It reveals the purchasing power of money, or the amount of goods and services that $1 will buy.
Statistics that are presented to us in nominal terms show us actual numbers before adjusting for changes in the level of prices, while statistics that are presented in real terms show us numbers that have been adjusted for inflation. Real data show us what something is worth in terms of its real purchasing power.
Lesson Objectives
Once you've completed this lesson, you'll be able to use the Consumer Price Index to:
- Determine inflation rates
- Observe changes in purchasing power
- Understand the differences between data given in real terms and data given in nominal terms
- Calculate real income
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Consumer Price Index | Definition, Example & Calculation
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