Business, Politics, & Society

What Is the Consumer Price Index (CPI) Formula And How Is the Consumer Price Index Used in Business?

Written by MasterClass

Aug 31, 2019 • 4 min read

Throughout the calendar year, economists and government regulators track the overall health of their respective nation’s economy. In the United States, entities such as the Bureau of Labor Statistics and the United States Federal Reserve keep tabs on a variety of economic indicators in order to assess trends and strategize for the economic future.

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What Is the Consumer Price Index?

The consumer price index is a tool that economic observers use to track inflation. It represents the average change in prices over time for all components of an economy. A consumption economy is comprised of many facets, including but not limited to:

  • Physical goods (such as food, electronics, vehicles, and clothing)
  • Professional services (such as those performed by hairstylists, tour guides, gardeners, and tutors)
  • Housing (such as apartment rent, mortgage payments, and outright sales of property)
  • Entertainment (such as live music, sporting event tickets, and cable subscriptions)
  • Health care (such as doctor’s appointments, medical procedures, and pharmaceuticals)

How Is the Consumer Price Index Calculated?

The consumer price index uses what’s known as a fixed “market basket” of goods and services from these categories in order to extrapolate a complete picture of the economy.

Once this “market basket” is established, its prices are then plugged into a formula to determine the CPI. The market basket is divided into eight categories:

  • Housing
  • Apparel
  • Transportation
  • Education
  • Food and beverages
  • Medical care
  • Recreation
  • Other goods and services

The prices in all of the categories are influenced by Americans’ patterns of consumption. In other words, if Americans are buying more houses, this will affect the measured prices in the “housing” section of the market basket.

The CPI is further subdivided into two categories, the CPI-W and the CPI-U. The following categories are defined as such by the United States Bureau of Labor Statistics:

  • The CPI-U is a more general index and seeks to track retail prices as they affect all urban consumers. It encompasses about 87% of the United States’ population.
  • The CPI-W is a more specialized index and seeks to track retail prices as they affect urban hourly wage earners and clerical workers. It encompasses about 32% of the United States’ population and is a subset of the CPI-U group. The CPI-W places a slightly higher weight on food, apparel, transportation, and other goods and services. It places a slightly lower weight on housing, medical care, and recreation.
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What Is the CPI Formula?

Once the consumer market basket is established, its values can be plugged into an equation known as the CPI formula. The formula to find the consumer price index (CPI) in a given year is:

CPI = (Cost of market basket in the given year/cost of market basket in base year) x 100

How Is the CPI Used?

The CPI is commonly used to measure the overall health of an economy and the effectiveness of a government’s economic policies. In particular, it offers data on the hourly and weekly earnings of workers and the prices they pay for all of their activities as consumers.

Is the CPI Accurate?

Over time, the consumer price index has proven itself as an accurate measure of inflation rates, the price of goods, and the purchasing power of Americans.

However, because it tracks a fixed market basket of goods and services, the CPI can be marginally susceptible to inaccuracies when tracking the prices of goods. Let’s say that the price of refrigerators was included in the CPI “market basket” but the price of dishwashers was not. If there was a massive spike in the price of dishwashers (but not in the price of refrigerators), the CPI wouldn’t register it. Over time, such minor inaccuracies tend to balance out, making the CPI a reliable indicator of market prices.

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How Is the CPI Related to GDP?

The consumer price index is a tool tied to a nation’s gross domestic product (GDP). GDP represents three separate conceptions of the strength of an economy:

  1. The value of everything that is produced within the country
  2. The value of everything that is purchased within the country plus that country’s net exports to other countries
  3. The income of all the individuals and businesses within the country.

These three values are the same because everything that we purchase must be first produced and then sold. Then, through the selling of products and services, we earn our income. Therefore, total production, total purchases, and total income for the whole country are the same. Measuring GDP tells us an enormous amount about how we are doing as a nation. If GDP is rising, it signifies that incomes are rising, and consumers are purchasing more. All of this means a stronger economy.

What Is the Difference Between the CPI and the GDP Price Deflator?

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The main difference between the CPI and the GDP price deflator is that the latter is a tool for comparing prices across different eras while specifically accounting for changes in the rate of inflation.

The GDP price deflator is a mathematical tool that allows economic observers to compare the gross domestic product of different eras while accounting for the changes in inflation between those eras. It does this by comparing the real GDP—the total value of goods and services in a particular era—with the nominal GDP, the value of those goods and services based on the contemporaneous value of a particular currency.

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