It’s widely used as a measure of inflation, along with the GDP deflator (see too GDP Deflator vs CPI). This permits economists and policymakers to spell out the financial performance and direct macroeconomic policy. Calculating Consumer Price Index (along with the inflation rate) follows a four-step process: 1) Repairing the market basket, 2) calculating the basket’s price 3) calculating the indicator 4) calculating the inflation rate. We’ll look at each of the four measures in more detail below.

## 1) Fixing the Economy Basket

The CPI market basket reflects all products and services which are bought for consumption by a particular reference inhabitant (e.g. the metropolitan population within the US).

The basket has been developed within a two-year interval from polls and diaries that gather detailed information from families (individuals and families ) seeing their day-to-day consumption expenses. In the united states, about 7’000 households from all over the nation to provide this information each quarter. Along with this, another 7’000 families record what they purchase in a journal for 2 weeks to gather info on frequently purchased items. This information is then thoroughly examined to find out the weight and value of the many items and categories from the basket. Though this approach has its own shortcomings, it provides an accurate representation of a normal consumer within the market.

To provide a very simple illustration, let us assume that the normal consumers in a market to buy a basket of just two products; ice cream and candy bars. By conducting polls, we find out on average each consumer purchases 4 ice cream cones and 8 candy bars. With this advice, we are now able to correct our market basket to 4 ice cream cones and 8 candy bars.

## 2) Enhancing the Basket’s Price

When the basket is repaired, another step in calculating the Consumer Price Index would be to discover the present and previous costs of goods and services. This permits us to figure out the purchase price of the whole basket at any given point in time. The key point to notice here is the market basket stays fixed, i.e. neither products nor services nor their amount varies. Therefore, the only variable is the price, which permits us to isolate the effects of price changes through recent years.

Revisiting our example have to discover the costs of ice cream and candy bars. In 2017, an ice cream cone prices USD 2 along with a candy bar sells at USD 1. Back in 2016, consumers just had to pay USD 1.90 to an ice cream cone and USD 0.80 to get a candy bar, which ends at a basket price of USD 14 (4 ice cream cones x USD 1.90 + 8 candy bars x USD 0.8). We can see that the price level has risen from 2016 to 2017.

Next, to really calculate the Consumer Price Index we will need to specify a foundation year. The foundation year functions as the standard against which many years are contrasted. It could be designated publicly, but for the sake of comparability, it’s common practice to maintain the identical foundation year for a couple of years before continuing on to a brand new one. The entire world bank now reports CPI data together with the foundation 2010.

The indicator is then calculated by dividing the purchase price of the basket of products and services in a given year (t) from the purchase price of the identical basket in the base (b).

At the base year, CPI consistently adds up to 100. This becomes evident if we examine our example. Obviously, the end result is 100. Thus we could say that the Consumer Price Index has risen from 100 from 2016 to 114,3 in 2017.

## 3) Computing the Expense Rate

Last, the calculated CPI may be used to calculate the inflation speed. More especially, the inflation rate is the percent change in the purchase price index from 1 period into the previous one. To compute it, we could use this formula.

Consequently, with this formulation, we could calculate the inflation rate for any given year so long as the CPI of the previous year is available.

## In Short

The Consumer Price Index (CPI) is an indicator that measures the average change in prices paid by consumers for products and services within a definite time period. Calculating Consumer Price Index (along with the inflation rate) follows a four-step process: 1) Repairing the market basket, 2) calculating the basket’s price 3) calculating the indicator 4) calculating the inflation rate.