The CPI is the index number which measures the changes in the prices of the consumer goods purchased by the consumer in the current year in comparison to the base year. The CPI takes into account a basket of goods. A basket of goods is a fixed set of consumer products and services whose price is evaluated at regular intervals often monthly or annually. Many countries have switched from the Wholesale Price Index to the CPI. The following formula is used to measure the inflation rate using CPI in an economy.
CPIt = ( Ct / C0 ) *100 Here : CPIt= Consumer Price Index at the current period Ct= Cost of the market basket in the current period. C0= Cost of the market basket in the base period. Despite its prevalent use, the CPI has always been subject to criticism and economists question whether it is the best measure of inflation. There have been many controversies about CPI and whether it overstates or understates the inflation rate. The following article will be analysing whether CPI is an appropriate measure of inflation or not. Other methods will also be dealt with and compared with CPI.
Before the evolution of the CPI, the Wholesale Price Index(WPI) was used. WPI is the index which is used to measure the average change in price in the sale of goods in bulk quantity by the wholesaler. Whereas CPI measures the change in price in the hands of the consumers. The following graph presents the change in the CPI and WPI in India from 2015 to 2021.
Source: https://www.indiamacroadvisors.com/page/category/economic-indicators/inflation-prices/wholesale-price-index/ From the graph it can be inferred that WPI underestimates the price changes in the hands of consumers. This is because WPI focuses on the prices at business level paid by the wholesalers while CPI estimates the impact of the price change on the final consumers. This is one of the reasons why the CPI is better than the WPI as it presents the actual state of the economy and reflects the inflation rate which affects the consumers. Since the microeconomic decisions of the consumers are based on the retail prices, WPI gives a skewed indication of the actual inflation in the economy.
Secondly, the WPI only includes goods while CPI also takes the services into consideration. For example, in India, 55% of the GDP is accounted by the services and hence it is very important to take these into consideration while calculating the index numbers. The change in prices of only fuel, manufacturing products and power are calculated in WPI whereas CPI measures the price changes in education, transport, communication, recreation, apparel, housing,food and medical care. This composition of the WPI was a major issue. This sometimes even makes the WPI change negative as can be seen from the graph. For example In India, WPI assigns nearly 15% weightage for the fuel group Any sharp movements in international prices of fuels and metals, therefore, lead to sharp changes in WPI. This was visible in 2009 when WPI inflation fell below 2%. During the same year, CPI inflation averaged nearly 11%. These are the basic reasons why major countries of the world have switched from the WPI to the CPI. Raghuram Rajan, the governor of RBI in 2013 claimed that, “Inflation should be measured based on the rise in the price of a basket of inflationary items that directly affects the common man. CPI-based inflation captures this better than WPI-based inflation.” Hence from the above testimonial, it can be said that CPI is a dynamic method of inflation measure.
Having discussed this, CPI as a method of measure of price index also attracts a fair share of criticisms. It is far from being a perfect measure and has many inherent weaknesses. A few of the problems in the CPI as a measure of inflation have been illustrated below.
STATIC BASKET OF GOODS
The major problem of CPI is that it considers a fixed basket of goods. This is highly criticised by many economists globally. The fixed basket of goods does not consider the changes in the pattern of consumption of the people. This assumes that consumers are locked inside the basket to buy exactly the same number of goods regardless of the price changes. For example, if the prices of oranges in Florida skyrocket, then people will definitely substitute Texas grapefruit for the Florida oranges. Since CPI is a fixed weight price index, these fluctuations would not be reflected there. In this way, the CPI generally overstates the inflation.
MANIPULATIVE METHOD
Over the time, the CPI has evolved as a Cost of Goods Index (COGI) and later as a Cost of Living Index (COLI). The Bureau of Labour Statistics (BLS) in U.S has revised the CPI many times to remove the biases which caused the CPI to overstate inflation. The new methodology considers the changes in the quality of goods and substitution. This changes the relative weighting of the goods in the basket. However the critics even view this method as a purposeful manipulation that allows the U.S government to report a lower CPI. DOES NOT CAPTURE INNOVATION.
David Ranson, an economist and analyst of U.S government also questions CPI as a measure of inflation. He did not claim that the CPI is manipulated but instead he had put forth the argument that there is a time lag involved in CPI. He claimed that as inflation initially affects commodity prices and therefore it might take several years for the commodity to work its way and be reflected in the CPI. Even the newly introduced products take years to be included in the CPI. There are many examples supporting this statement. By 1996, there were 40 million subscribers of cell phones in the U.S, however the cell phones were not a part of the CPI till then. Hence the parade of inventions continued but the CPI always lagged behind. Leaving behind the new goods in the CPI, it is actually overlooking one of the ways in which the cost of living is improving in the economy. AN URBAN MEASURE
Other limitations include that the CPI is purposely constructed to measure the change in the buying habits of the urban people. It does not provide an accurate account for the change in prices in suburban and rural areas. While cities are the most important economic centres , still the population resides in the rural areas as well. Hence, it can be said that CPI is not an appropriate measure of inflation. A new measure of inflation named GDP Deflator which is said to better than CPI or WPI is evolving. The GDP deflator or the implicit price deflator, measures the changes in prices for all of the goods and services produced in an economy
A major advantage of the GDP Deflator is that it assigns changing weights to the prices of the different goods unlike the CPI which assigns fixed weights. The fixed basket used in CPI calculations is static and since GDP isn’t based on a fixed basket of goods and services, the GDP price deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator but not in the CPI. Apart from it, the GDP Deflator measures the prices of all the goods and services produced in the economy whereas CPI only measures the ones being consumed.There are many shortcomings of this method of measurement as well. For example. GDP Deflator is limited to the geographical boundaries of the nation. There are many ways in which even the CPI is better than the GDP Deflator.
Till date , the economists are researching to find out better methods of inflation. Many new methods of Inflation measurement have been formulated but none near the perfection mark. From the above discussion, it can be safely inferred that CPI definitely is not the perfect measure for inflation and new methods are evolving with time. The new method should be able to overcome all the demerits of CPI. The basket of goods should be dynamic and should not have fixed weights. The problem of understating and overstating inflation should also be considered. Hence it should be a dynamic method assimilating all the positive elements from the previously known methods of calculation.
Tanvi BansalWriting Mentorship 2021
References
1. https://www.wallstreetmojo.com/wpi-vs-cpi/#:~:text=WPI%20is%20used%20to%20measure,goods%20as%20well%20as%20services. 2. https://www.investopedia.com/terms/g/gdppricedeflator.asp 3. https://www.investopedia.com/terms/c/consumerpriceindex.asp 4. https://www.bls.gov/news.release/pdf/cpi.pdfgetRandomImage(‘CPI-Inflation-and-Shortfall’)
CPIt = ( Ct / C0 ) *100 Here : CPIt= Consumer Price Index at the current period Ct= Cost of the market basket in the current period. C0= Cost of the market basket in the base period. Despite its prevalent use, the CPI has always been subject to criticism and economists question whether it is the best measure of inflation. There have been many controversies about CPI and whether it overstates or understates the inflation rate. The following article will be analysing whether CPI is an appropriate measure of inflation or not. Other methods will also be dealt with and compared with CPI.
Before the evolution of the CPI, the Wholesale Price Index(WPI) was used. WPI is the index which is used to measure the average change in price in the sale of goods in bulk quantity by the wholesaler. Whereas CPI measures the change in price in the hands of the consumers. The following graph presents the change in the CPI and WPI in India from 2015 to 2021.
Source: https://www.indiamacroadvisors.com/page/category/economic-indicators/inflation-prices/wholesale-price-index/ From the graph it can be inferred that WPI underestimates the price changes in the hands of consumers. This is because WPI focuses on the prices at business level paid by the wholesalers while CPI estimates the impact of the price change on the final consumers. This is one of the reasons why the CPI is better than the WPI as it presents the actual state of the economy and reflects the inflation rate which affects the consumers. Since the microeconomic decisions of the consumers are based on the retail prices, WPI gives a skewed indication of the actual inflation in the economy.
Secondly, the WPI only includes goods while CPI also takes the services into consideration. For example, in India, 55% of the GDP is accounted by the services and hence it is very important to take these into consideration while calculating the index numbers. The change in prices of only fuel, manufacturing products and power are calculated in WPI whereas CPI measures the price changes in education, transport, communication, recreation, apparel, housing,food and medical care. This composition of the WPI was a major issue. This sometimes even makes the WPI change negative as can be seen from the graph. For example In India, WPI assigns nearly 15% weightage for the fuel group Any sharp movements in international prices of fuels and metals, therefore, lead to sharp changes in WPI. This was visible in 2009 when WPI inflation fell below 2%. During the same year, CPI inflation averaged nearly 11%. These are the basic reasons why major countries of the world have switched from the WPI to the CPI. Raghuram Rajan, the governor of RBI in 2013 claimed that, “Inflation should be measured based on the rise in the price of a basket of inflationary items that directly affects the common man. CPI-based inflation captures this better than WPI-based inflation.” Hence from the above testimonial, it can be said that CPI is a dynamic method of inflation measure.
Having discussed this, CPI as a method of measure of price index also attracts a fair share of criticisms. It is far from being a perfect measure and has many inherent weaknesses. A few of the problems in the CPI as a measure of inflation have been illustrated below.
STATIC BASKET OF GOODS
The major problem of CPI is that it considers a fixed basket of goods. This is highly criticised by many economists globally. The fixed basket of goods does not consider the changes in the pattern of consumption of the people. This assumes that consumers are locked inside the basket to buy exactly the same number of goods regardless of the price changes. For example, if the prices of oranges in Florida skyrocket, then people will definitely substitute Texas grapefruit for the Florida oranges. Since CPI is a fixed weight price index, these fluctuations would not be reflected there. In this way, the CPI generally overstates the inflation.
MANIPULATIVE METHOD
Over the time, the CPI has evolved as a Cost of Goods Index (COGI) and later as a Cost of Living Index (COLI). The Bureau of Labour Statistics (BLS) in U.S has revised the CPI many times to remove the biases which caused the CPI to overstate inflation. The new methodology considers the changes in the quality of goods and substitution. This changes the relative weighting of the goods in the basket. However the critics even view this method as a purposeful manipulation that allows the U.S government to report a lower CPI. DOES NOT CAPTURE INNOVATION.
David Ranson, an economist and analyst of U.S government also questions CPI as a measure of inflation. He did not claim that the CPI is manipulated but instead he had put forth the argument that there is a time lag involved in CPI. He claimed that as inflation initially affects commodity prices and therefore it might take several years for the commodity to work its way and be reflected in the CPI. Even the newly introduced products take years to be included in the CPI. There are many examples supporting this statement. By 1996, there were 40 million subscribers of cell phones in the U.S, however the cell phones were not a part of the CPI till then. Hence the parade of inventions continued but the CPI always lagged behind. Leaving behind the new goods in the CPI, it is actually overlooking one of the ways in which the cost of living is improving in the economy. AN URBAN MEASURE
Other limitations include that the CPI is purposely constructed to measure the change in the buying habits of the urban people. It does not provide an accurate account for the change in prices in suburban and rural areas. While cities are the most important economic centres , still the population resides in the rural areas as well. Hence, it can be said that CPI is not an appropriate measure of inflation. A new measure of inflation named GDP Deflator which is said to better than CPI or WPI is evolving. The GDP deflator or the implicit price deflator, measures the changes in prices for all of the goods and services produced in an economy
A major advantage of the GDP Deflator is that it assigns changing weights to the prices of the different goods unlike the CPI which assigns fixed weights. The fixed basket used in CPI calculations is static and since GDP isn’t based on a fixed basket of goods and services, the GDP price deflator has an advantage over the CPI. For instance, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator but not in the CPI. Apart from it, the GDP Deflator measures the prices of all the goods and services produced in the economy whereas CPI only measures the ones being consumed.There are many shortcomings of this method of measurement as well. For example. GDP Deflator is limited to the geographical boundaries of the nation. There are many ways in which even the CPI is better than the GDP Deflator.
Till date , the economists are researching to find out better methods of inflation. Many new methods of Inflation measurement have been formulated but none near the perfection mark. From the above discussion, it can be safely inferred that CPI definitely is not the perfect measure for inflation and new methods are evolving with time. The new method should be able to overcome all the demerits of CPI. The basket of goods should be dynamic and should not have fixed weights. The problem of understating and overstating inflation should also be considered. Hence it should be a dynamic method assimilating all the positive elements from the previously known methods of calculation.
Tanvi BansalWriting Mentorship 2021
References
1. https://www.wallstreetmojo.com/wpi-vs-cpi/#:~:text=WPI%20is%20used%20to%20measure,goods%20as%20well%20as%20services. 2. https://www.investopedia.com/terms/g/gdppricedeflator.asp 3. https://www.investopedia.com/terms/c/consumerpriceindex.asp 4. https://www.bls.gov/news.release/pdf/cpi.pdfgetRandomImage(‘CPI-Inflation-and-Shortfall’)