Consumer Price Index - Calculation of the CPI - Homework Help

What do you understand by the term CPI?

¨      It measures the amount of commodities and services a given sum of money can buy.

¨      Also known as purchasing power or internal value of money.

¨      General Price changes will affect the value of money.

Definition: CPI is a figure that measures the relative changes in the general price level from a base year to a current year.

Steps Involved in the Calculation of the CPI

i.        Selection of a base year

ii.      Selection of a basket of commodities and services.

iii.    Gather information on prices for base year and current year.

iv.    Assign weights to each good and service according to their relative importance.

v.      Calculate relative price changes between base year and current year and multiply this by the weights.

vi.    Total the amount (i.e. relative prices x weights) and divide it by the total weights.

Illustration

 

Items

(per kg)

Prices

Relative prices

Weight

Relative prices

X weight

Yr 1       

Yr 2

Yr 1

Yr 2

 

Yr 1

Yr 2

 

A

B

C

 

1.00

3.00

5.00

 

1.80

4.50

6.30

 

100

100

100

 

180

150

126

 

6

3

1

 

600

300

100

 

1080

450

126

 

 

 

 

 

10

1000

1656

 

Weighted price index for Yr 1 =    100     

Weighted price index for Yr 2 =    165.6                                      

Importance of CPI

Price indices are of importance to the government, firms and traders and to the trade union.

i.        The Government use these indices as denominator to measure other economic indictors such as :-

  • Real GNP
  • Cost of living and hence standards of living
  • Ensure exchange rate stability

ii.      Firms and traders use these indices to adjust their profit margin especially when cost of production changes.

iii.    Trade Union uses these indices in their wage negotiation with the employers.

Problems Involve in the Construction of CPI

¨      Difficulty in choosing a base year

¨      Difficulty in assigning weights to each commodity according to their relative importance since these weights change from time to time

¨      As taste and preference change from time to time, it is misleading to assume that the same amount will be spent

¨      Difficulty involve in the collection of accurate information on household expenditure pattern as people resent to such enquiries

¨      Difficult to include all range, grades or quality of goods in the market

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