Inflation

Price Indexes

Price indexes measure the change in prices of selected goods over time. They are often used to track inflation and gauge the strength of an economy.
A price index is a measure that examines the weighted average of prices of a basket of goods and services. A basket of goods is a theoretical container consisting of selected goods or services that economists can use to understand prices. Price indexes show the change in the average price (the amount of money paid to acquire a good or service) or a group of prices over time, such as one month, one quarter (every three months), or one year. Price indexes can increase or decrease. For example, a consumer may pay $2.50 for a loaf of bread one year and $2.75 the next year. A price index—such as the Consumer Price Index (CPI)—reflects this change. The Consumer Price Index is a measure that examines the average of prices of a basket of goods and services bought by consumers, weighted according to the amount of each good purchased.

Price indexes were first developed to figure out how people could earn enough money to afford the same goods and services each year, even when prices rose. By comparing price indexes year over year, economists can tell whether the price level is increasing or decreasing in an economy. For example, Lily earned $3,000 per month and spent about $500 on food. Then the price of food rose, and she was paying $575 for the same amount of food each month. This means that Lily now has $75 less to spend on other things. If the prices of too many of Lily's purchases increase, then she may not be able to afford the same things she used to buy if she still earned $3,000 per month. Cost of living refers to the average amount of money needed to afford necessary or usual goods, such as housing and food. Price indexes can indicate how much employers must increase wages (money paid by an employer in exchange for work) so people like Lily can afford the same standard of living after inflation occurs.

Consumer Price Index

The Consumer Price Index (CPI) is calculated by using the price changes for each good and service in its market basket over a specific time period.
The Consumer Price Index (CPI) is measure that examines the weighted average of prices of a basket of goods (commodities used to satisfy a want or need) and services bought by consumers. It includes a weighted average of the prices of commonly used goods and services from eight main groups:
  • food and beverages
  • housing (such as rent and furniture)
  • apparel (such as clothing and jewelry)
  • medical care (such as medications and hospital visits)
  • transportation (such as airline tickets and fuel)
  • recreation (such as televisions and pet care)
  • education and communication (such as college tuition and postage stamps)
  • other goods/services (such as haircuts and tobacco products)

Many people from all over the country buy these goods and services. The CPI reflects about 89% of those people—called urban consumers, or people who live in cities and metropolitan areas. This group includes professionals, the unemployed, and retired people. There are several groups of people whose purchases are not reflected in the CPI, including farm families and people in the armed forces.

Calculating the CPI begins with the fixed basket of goods and services, or the products from the eight main groups. A U.S. government agency called the Bureau of Labor Statistics surveys consumers to find out how they spend their money. The Bureau of Labor Statistics creates a sample market basket of goods based on these surveys. Each quantity is then multiplied by its price in a specific year to find out the cost of the market basket in that year. For example, suppose one shirt cost $7 in 2016. If the basket contains 10 shirts, then the total cost of shirts in the basket is $70.

For comparisons, a base year is used. A base year can be randomly chosen, but when two years are compared, the base year is the earliest one. Once a year is chosen as the base year, all prices for goods will be converted to the equivalent prices from that year. Calculating the CPI means dividing the cost of the basket of goods in a given year, GY, by the cost of the same fixed basket in the base year, BY, and then multiplying the quotient by 100.
GYinflationrate=CPIGYCPIBYCPIBY×100GY\;\mathrm{inflation}\;\mathrm{rate}\;=\frac{CPI_{GY}-CPI_{BY}}{CPI_{BY}}\times100
So, if comparing the cost of market baskets for 2015 and 2016, 2015 is the base year.
2016inflationrate=CPI2016CPI2015CPI2015×1002016\;\mathrm{inflation}\;\mathrm{rate}\;=\frac{CPI_{2016}-CPI_{2015}}{CPI_{2015}}\times100
The CPI in 2015 was 237, and the CPI in 2016 was 240. So, the inflation rate in 2016, rounded to the nearest tenth, was the difference (3) divided by the base CPI (237) and then multiplied by 100 to get 1.3%.
240237237×100=3237×100=1.3%\frac{240-237}{237}\times100=\frac3{237}\times100=1.3\%
When comparing CPIs, the quantity of each good and service in the basket stays the same; only the prices change to reflect the year. Suppose the basket includes 10 shirts and 5 hats. In 2010, one shirt cost $5.80 and one hat cost $2.50, but in 2015, one shirt cost $7 and one hat cost $3.25. When comparing CPIs in 2010 and 2015, the total cost of the 2010 fixed basket would include $70.50 in shirt and hat costs, but the total cost of the 2015 fixed basket would include $86.25 in shirt and hat costs.

Calculating the CPI

Year Number of Shirts Price of Shirts Cost of Shirts Number of Hats Price of Hats Cost of Hats Nominal Value of Goods CPI
2005 (base year) 10 $4.30 $43.00 5 $2.00 $10.00 $53.00 100.0
2010 10 $5.80 $58.00 5 $2.50 $12.50 $70.50 133.0
2015 10 $7.00 $70.00 5 $3.25 $16.25 $86.25 162.7

CPI is calculated by dividing the total cost of a basket of goods in a given year by the total cost of a basket in a base year and multiplying by 100.

CPI=(Costoffixedbasketingivenyear)(Costoffixedbasketinbaseyear)×100\mathrm{CPI}=\frac{(Cost\;of\;fixed\;basket\;in\;given\;year)}{(Cost\;of\;fixed\;basket\;in\;base\;year)\;\;}\times100
In this case, the base year is 2005. The CPI for 2010 is $73.50/$53.00×100=133.0\$73.50/\$53.00\;\times\;100=133.0 . The CPI for 2015 is $86.25/$53.00×100=162.7\$86.25/\$53.00\;\times\;100=162.7 .

Consumer Price Index

If the given year is the base year, then the costs of the basket of goods in both the given year and the base year are the same. This means the CPI in the base year is always 100. Comparisons of CPIs show changes in average prices between years. These changes can be positive or negative.
In the 20th century, the U.S. Consumer Price Index (CPI) has generally increased. However, there were periods of deflation when the CPI showed that prices of commonly bought goods and services in the country decreased. Over the years, prices have changed, and so has the basket of goods and services used. In 1950, about 33% of the fixed basket used was food. By 2015, food was only about 14% of the basket.

Producer Price Index

The Producer Price Index (PPI) measures the average change in selling prices from domestic producers for their goods and services.
The Producer Price Index (PPI) is a measure that examines the weighted average of prices at the producer level. Like the CPI, the PPI can be used to assess the overall change in prices in an economy. The PPI includes both of the following:
  • goods and services bought by consumers from sellers (such as stores) or directly from producers
  • goods and services bought by producers as inputs or investments, such as stock supplies for manufacturing or improvements to facilities
When companies sell their goods, they want to earn profits (money in excess of their costs). To do this, businesses choose prices for their products that are higher than the costs of making them. If the cost of their inputs (goods and services necessary to produce the product) rise, businesses will likely increase the prices of their products. Thus, the consumer will end up paying (at least in part) for the price increase. The PPI measures the average change in selling prices from domestic producers for their goods and services. A weighted average means that certain values have more significance. The PPI compares the average cost of a fixed basket of products over time. The PPI has three groups: commodities, processing stage, and finished goods.
The Producer Price Index (PPI) is calculated based on the perspective of producers rather than consumers. It includes goods and services bought by both consumers and other producers. Gray bars represent recessions. When the PPI = 100, this is considered the base year.
The PPI can be useful to compare the rates between different economies to gain insight on how the economies are interacting with each other. Comparing PPIs between countries can show how connected the economies are.

A commodity is a good that is bought and sold in a commercial transaction and is interchangeable with other goods of the same type, such as grains, metals, and oil. The PPI Commodity Index records average price changes for the goods in this market. Manufacturing deals with making and putting together parts for finished goods, such as making car parts to produce a car. Processing stage refers to the manufacturing phase, when products are between the raw and finished stages.

The wholesale market includes the sales of finished goods to retailers. A finished good is a good that has completed all phases of manufacturing but has not yet been sold. Suppose a company makes shirts. The company then sells the shirts to a distributor. The distributor sells the shirts to retailers for consumers to buy. In this case, the distributor is the wholesaler. Wholesalers sell large quantities of goods at low prices. Companies such as Target and Walmart are retailers that buy the wholesalers' goods in large quantities and then sell these goods to consumers. The PPI can change in many different ways. Generally, it increases based on inflation, but it can also decrease or stay the same.

The PPI includes many industries but not all of them. For example, food and energy industries are not part of the PPI. People use the PPI to examine trends (general directions in the market) for industries and markets in manufacturing, commodities, and wholesale. As for the CPI, a base year is chosen to compare PPIs from different times. The PPI and the CPI follow similar general trends; when one goes up, often the other will rise as well. The two ways of measurement are connected based on the influence of the production chain. Although related, the CPI is different from the PPI because it includes imports.
There is a strong correlation between the producer price index (PPI) and the consumer price index (CPI) because the value of a good tends to be similar whether it is observed in terms of how much it costs to produce it or how much consumers pay for it.