Price Level, Inflation and Consumer Price Index

The Price Level and Inflation:

The Consumer Price Index:

The most regularly seen measure of overall price level is Consumer Price Index, or CPI. (Other measures of prices comprise, to name three, Producer Price Index of prices paid not by the consumers but by the corporations, economy-wide GDP deflator, and Domestic Purchases deflator.) The CPI is computed and accounted one time a month by ‘Bureau of Labor Statistics’. The CPI is expenditure weighted index, in that each merchandise or service gets a weight equivalent to its share in whole expenditure in the base year.

Using relative expenditure levels in a preset base year as weights in a price index generates produces a kind of index which economists name as Laspeyres index. The CPI is such a Laspeyres price index. Another category of index, a Paasche index, is in a sense which is opposite of a Laspeyres index. A Laspeyres index of production or consumption calculates the current dollar worth of what is consumed or produced, and divides by what the value of what is consumed or produced would have been if every commodity had sold for their prices in base year. The expenditure weights in a Paasche index are changeable: if expenditures on a individual good arise this year so it’s a large fraction of the current dollar value, then that good's weight in price index will rise also. The second most often seen index of price level, the GDP deflator, is a Paasche index.

In broad, a Laspeyres index overstates price raises. In the actual world, when some items become costly consumers substitute and instead buy other items which remain inexpensive. But a Laspeyres index, hence it is based on fixed bazaar basket of goods and services, doesn’t take account of this substitution. So it suffers from what economists call substitution bias, and have a tendency to overstate changes. A Paasche index, conversely, understates the raise in fruit costs. It computes the difference between price today of the fruit you purchased and their price back in base year. The Paasche index takes account of replacement. But it does not take account of fact that substituted items are less valued than items they substitute. The Paasche index accounts, for example of Box 2.5, where skyrocketing price of oranges hasn’t any effect on fruit prices: it doesn’t make any sense to say that a frost which makes oranges totally unaffordable has not any effect on price of fruit.

So which one is the correct price index? The answer is that there is none. There is not any final and definitive resolution to this “index number problem.’ None of the price indices is perfect. All try to précis in a single number that is inherently a multi-dimensional reality of numerous prices changing in different directions and different proportions.

To strike a stability between the two types of indices and their two types of biases, the ‘Commerce Department's Bureau of Economic Analysis’ and the ‘Labor Department's Bureau of Labor Statistics’ have begun to approach hybrid indices. To decrease substitution bias, the ‘Bureau of Labor Statistics’ has started using geometric averages, Multiply two numbers together and calculate the square root, instead of arithmetic averages. And the ‘Bureau of Economic Analysis’ has started using a method called ‘chain weighting’ to construct its indexes.

The Inflation Rate

The CPI is reported one time a month in the form of percentage change in customer prices over the previous month. "Customer prices in November increased 0.3 percent above their stage in October," a newscaster would say. Ultimately, 12 monthly changes in customer prices over the course of year are added up and become that year's inflation rate. The newscaster would say "The consumer price inflation rate in 1999 was 2.7%."

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Figure: Different Measurements of Inflation in the U.S., 1960-2000

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