The Consumer Price Index (CPI) is a key indicator used to gauge inflation. More precisely, it tracks retail inflation by gathering data on the prices of goods and services commonly consumed by the country's population. In essence, the CPI reflects the rise in the price level of a chosen basket of goods and services over a specified period.
In this article, we will study the meaning of CPI, learn how it works, and explore its calculations. We will also understand the benefits and limitations of CPI.
What is Consumer Price Index (CPI)?
The Consumer Price Index (CPI) measures changes in the price levels of goods and services consumed by retail buyers, who represent the demand side of the economy. As such, CPI can also be seen as an indicator of the purchasing power of a currency.
CPI is calculated based on a fixed basket of goods and services, which the government may adjust periodically. It serves as a key macroeconomic indicator of inflation and is a vital tool used by central and state governments, as well as the Reserve Bank of India, to regulate money supply and ensure price stability.
What does CPI indicate?
The Consumer Price Index provides insights into the following:
- Cost of living
- Consumers' purchasing power
- The costliness of various goods and services purchased by consumers
- The value of the Indian rupee
How does the consumer price index work?
The consumer price index measures the average change over time in the prices consumers pay for a basket of goods and services. It shows how much more or less expensive everyday items are compared to previous months or years.
A "market basket" is used to calculate the CPI. This basket includes common goods and services people usually buy, such as food, clothing, healthcare, and transportation. The prices of the items in this market basket are tracked over time in the following manner:
- If the prices go up, the CPI increases, which indicates inflation.
- If prices go down, the CPI decreases, which indicates deflation.
The primary purpose of CPI is to measure the purchasing power of consumers. For example, assume the CPI shows a significant increase. Now, this means that the cost of living has gone up and people need to spend more money to maintain their standard of living.
Moreover, CPI is different from the Wholesale Price Index (WPI). While CPI measures price changes at the consumer level, WPI measures price changes at the wholesale level (before the goods reach consumers).
Features of Consumer Price Index – CPI
The consumer price index is a popular economic indicator widely used to determine how prices for everyday items are changing. It does so by tracking the price movements of essential items and provides insights into the purchasing power of consumers and the overall economic health. For more clarity, let’s study some of its key features:
Feature |
Description |
Tracks inflation |
Measures the average price change of a basket of goods and services over time, essentially calculating inflation. |
Measures purchasing power |
Helps determine the value of a currency unit within an economy by indicating its purchasing power for goods and services. |
Weighted average |
Uses a weighted average of prices for goods and services, reflecting typical consumer spending patterns. |
Focuses on Retail Goods |
Primarily measures price changes for retail goods and services purchased by consumers, excluding savings, investments, and foreign visitor spending. |
Target population |
Considers the spending patterns of various segments like employed, self-employed, and low-income individuals, but excludes non-urban populations, rural families, and some specific groups. |
Types of CPI |
Different CPIs exist for various economic segments, but commonly tracked forms include: * CPI-U (for all Urban Consumers) * CPI-W (for Urban Wage Earners and Clerical Workers) |
Types of Consumer Price Indexes (CPIs)
India has several types of Consumer Price Index (CPI), including:
- CPI for Industrial Workers (CPI-IW): Tracks price changes in a basket of goods and services used by industrial workers. It is used to calculate the dearness allowance for workers in both private and public sectors.
- CPI for Agricultural Labourers (CPI-AL): Determines the minimum wages for laborers in the agricultural sector.
- CPI for Rural Labourers (CPI-RL): While based on the same rural retail prices as CPI-AL, the weighting diagrams differ.
- CPI for Urban Non-Manual Employees (CPI-UNME): Published by the Central Statistical Organisation, this index is specific to urban non-manual employees.
- CPI (Rural/Urban/Combined): Another variant of the CPI.
The CPI measures price changes from the perspective of a retail consumer and is released by the National Statistical Office (NSO). It serves as a key macroeconomic indicator for inflation and is used by governments and central banks for inflation targeting and maintaining price stability.
CPI Formula
To calculate the CPI, you have to divide the cost of the market basket in the given year by the cost of the market basket in the base year. Then, the obtained result needs to be multiplied by 100 to get a percentage. Mathematically, we can represent this as follows:
CPI % = (Cost of the market basket in given year / Cost of the market basket in base year) x 100
For the uninitiated, CPI tracks the prices of items included in a “market basket”, which is a collection of goods and services that people usually buy, like food, clothing, transportation, and medical care. Such tracking explains how the cost of living has changed over time.How is CPI Calculated?
At its core, the CPI represents the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI formula calculation in India follows a systematic process:
- Selection of a market basket: The first step involves defining a basket of goods and services, reflecting the spending habits of the typical consumer.
- Price collection: Prices for these items are then collected regularly from various cities across the country.
- Weight assignment: Each item in the basket is assigned a weight, reflecting its importance or share in the average household's expenditure.
- Index calculation: The price of the basket in the current period is compared to the price of the basket in the base period, resulting in the CPI.
Consumer price index formula -
CPI = (Cost of market basket in a given year / Cost of market basket in base year) x 100
The above is the CPI formula.
For example, if the total price of the basket was Rs. 5,00,000 in the base year and Rs. 5,50,000 in the current year, the CPI would indicate a 10% increase in the cost of living over this period.
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How is CPI Calculated in India?
Calculating the Consumer Price Index (CPI) involves tracking the prices of a broad basket of goods and services that the average Indian consumes. This extends beyond just food and clothing to include expenses like transportation, healthcare, electricity, education, and nearly all areas of expenditure.
- The CPI is expressed as a percentage and compares the current price levels of goods and services in a specific time period with a base year in the past. This base year serves as the reference point for calculation.
- The base year is determined by the Central Statistics Office (CSO), under the Ministry of Statistics and Programme Implementation (MoSPI), and is updated periodically. The most recent base year change was from 2010 to 2012, effective from January 2015.
- Goods and services in the CPI basket are categorized into different groups such as food and beverages, clothing, housing, fuel and light, recreation, etc., with each category assigned a specific weight. Data for CPI is gathered by the National Statistical Office (NSO) from 1,181 village markets and 1,114 urban markets across 310 towns and cities in India.
Currently, the CPI is calculated using 299 items in the basket.
Benefits of consumer price index
The CPI is a valuable tool for understanding economic conditions. Often, it guides government policies and helps in adjusting economic data. To understand better, let’s have a look at some major benefits and uses of the consumer price index:
- The CPI is a key measure of economic health. It shows how the prices of goods and services are changing over time. This information helps to understand the purchasing power of consumers and the value of the currency.
- The CPI helps evaluate the effectiveness of government economic policies. Ideally, effective policies keep inflation (price increases) under control.
- The data obtained from CPI is commonly used to adjust other economic indicators, such as national income. For example, if the prices of goods and services increase, the national income figures can be adjusted to reflect the real value of money.
- The CPI is used to adjust wages, salaries, and social security benefits to keep up with inflation. This ensures that the income earned by these sections of society can still cover their living expenses even when prices increase (inflation).
What is Core CPI?
Core CPI excludes volatile food and energy prices to provide a clearer view of underlying, long-term inflation trends. This measure is vital for policymakers and economists, offering a more stable inflation indicator that excludes items subject to external shocks and seasonal variability.
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CPI vs core CPI
The consumer price index measures the average change in prices over time that consumers pay for a basket of goods and services. It is expressed as a percentage and is calculated by comparing the current general price level in the markets to that of a previous period, referred to as the “base year”.
On the other hand, core CPI is a variation of the consumer price index. It specifically excludes “food” and “energy” from its calculation. The rationale behind excluding these items is that:
- The prices of food and energy prices are highly volatile
and - This volatility can distort the overall inflation picture
Hence, by removing these categories, core CPI aims to provide a clearer view of the long-term inflation trends by ignoring short-term fluctuations caused by food and energy prices.
So, CPI provides a comprehensive picture of inflation or an overall measure of the cost of living and inflation experienced by customers. Conversely, core CPI shows long-term inflation trends without reacting to temporary price spikes.
Example for CPI
Say you want to calculate the CPI for the year 2024, using 2010 as the base year. As a first step, you must collect prices for the items of the “basket of goods and services” for 2024 and 2010. Consider the prices (hypothetical) collected in the table below:
Item |
Price in 2010 (in Rs.) |
Price in 2024 (in Rs.) |
Rice per kg |
20 |
40 |
Wheat per kg |
15 |
30 |
Milk per litre |
25 |
50 |
Bus fare (per trip) |
10 |
20 |
School fees (per month) |
1,000 |
2,000 |
Now, we will calculate the cost of the basket by simply adding the above values for each year:
- Total cost of the basket in 2010:
- Rs. 20 (Rice) + Rs. 15 (Wheat) + Rs. 25 (Milk) + Rs. 10 (Bus fare) + Rs. 1,000 (School fees) = Rs. 1,070
- Total cost of the basket in 2024:
- Rs. 40 (Rice) + Rs. 30 (Wheat) + Rs. 50 (Milk) + Rs. 20 (Bus fare) + Rs. 2,000 (School fees) = Rs. 2,140
Lastly, to calculate CPI, we will apply its formula:
CPI = (Cost of the market basket in a given year / Cost of the market basket in the base year) x 100
CPI = (2,140/ 1,070) x 100 = 200%
Here, we can observe that the CPI for 2024 is 200%. This indicates that the prices have doubled (increased by 100%) since 2010, the base year.
Uses of the Consumer Price Index
The CPI finds its application across various domains, including:
- Inflation measurement: It's the most widely used indicator of inflation, reflecting the cost of living changes over time.
- Economic analysis: Businesses, investors, and policymakers analyse CPI trends to make informed decisions.
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Limitations of the Consumer Price Index
Despite its significance, the CPI has its limitations, such as:
- Coverage: The CPI may not account for all out-of-pocket expenditures, missing some aspects of the cost of living.
- Measurement Issues: Challenges like substitution bias, where consumers switch to cheaper alternatives as prices change, can affect the CPI's accuracy.
Consumer price index for May 2024 - Latest update
In May 2024, India's consumer price index inflation rate was 4.75%, slightly lower than the 4.83% recorded in April 2024. The inflation rate in rural areas was 5.28%, while in urban areas, it was 4.15%, indicating that prices rose more in rural areas compared to urban areas.
The consumer food price index (CFPI) inflation, specifically measuring the price changes in food items, was 8.69% in May 2024, just slightly down from 8.70% in April 2024. Notably, the overall CPI inflation rate for May 2024 is the lowest since May 2023.
Additionally, the inflation rate has remained below 6% since September 2023, reflecting a period of relatively stable prices. Certain categories, such as spices, clothing and footwear, housing, and miscellaneous, have seen decreases in their inflation rates compared to April 2024.
Furthermore, the index of industrial production (IIP), which measures the output of various industrial sectors, grew by 5% in April 2024, showing a slight increase from the 4.6% growth recorded in April 2023. Breaking it down by sectors:
- Mining grew by 6.7%
- Manufacturing by 3.9%, and
- Electricity by an impressive 10.2%
Conclusion
Understanding what CPI is pivotal for navigating the complexities of the economy and making informed financial decisions. Whether you're a policy maker, investor, or just looking to understand more about how changes in the economy might affect you, grasping the fundamentals of the CPI is a crucial step in demystifying the economic indicators that shape our lives.
