Measuring CPI in US Economy

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Consumer Price Index to calculate Inflation
Sukhwinder Singh
Principles of Finance FIN-320
Prof. Zeno Gavales
July 25
th
, 2014














Measuring CPI in US Economy

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According to the U.S. Bureau of Labour Statistics, the Consumer Price Index (CPI)
measures the average change in prices paid by the U.S. customers for sampling goods and
services over a specific period of time in their routine life. It is represented as the percentage
of cost of same service or good in a base time period. The CPI is used as the best tool to
measure the change in cost of living in America which is most commonly known as Inflation.
For example, if the price of a chair in 1990 was $100 and same chair was sold for $155 in
2000, then this means that prices for this good had increased by 55% over the period of 10
years. The U.S. Bureau of Labour Statistics started calculating CPI in 1917 and since then it
is calculated monthly. We know that CPI is a methodology used to the Economists to
calculate inflation rate, there are many advantages and disadvantages in its usage.
The CPI affects U.S. economy in many ways. The high annual percentage of CPI
reflects high rate of inflation. The Federal Reserve which controls the money supply reacts to
these changes in CPI. If the inflation rate is high, then it also increases the interest rate. This
makes the borrowing of money more expensive for businesses and individuals which further
leads to more savings for both which further help to curb the inflation. It also determines the
annual percentage change in income of American people. The cost of living adjustment
(COLA) index formula which is used in many employment contracts is based in CPI. The
Federal Government uses CPI to adjust Social Security and Disability benefits, to determine
the new tax brackets and also to establish the revised income levels which determine if
individuals are eligible for assistance programs. Another positivity of CPI is that it does
adjustments to remove the effect of seasonal factors on price changes e.g. rise in heating oil
price in winter time. The CPI compares the dollar value of same goods and services over
specific period of times.
Some economists believe that CPI index have overstated actual increase in prices or
cost of living over the years. The CPI index is biased and doesnt present the true picture of
Measuring CPI in US Economy

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reality. It generally attributes discrepancies such as in measurement of improvement of
quality of goods, ignores substitution of goods and services, introduction of new products in
market and difficulty of measuring the price paid by consumers for same goods nationwide.
CPI measures price of goods and services paid by urban customers only and completely
ignores rural consumers, business sector, purchases made by government and foreign sector.
Urban consumers contribute 60% of the economys aggregate production, rest of the sectors
are remaining 40%, and therefore, CPI does miss these prices in calculations.

In a large economy such as the U.S. measurement of price change is sufficiently
complex. Therefore, the accuracy of an estimated inflation rate to gauge and justify can be
highly debatable. The CPI cant be claimed as precise and accurate measure of inflation.
Bureau of Labour Statistics has addressed various potential sources of bias in CPI in past,
though there will always be a continuous debate on to what extend the bias can exist in the
measurement. BLS is has been working actively to find solutions for these concerns in order
to increase accuracy in CPI.




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Reference
Consumer Price Index (CPI) - benefits. (n.d.). Retrieved July 25, 2014, from
http://www.referenceforbusiness.com/encyclopedia/Con-Cos/Consumer-Price-Index-
CPI.html
Reed, S. B., & Rippy, D. A. (2012, August). Consumer Price Index data quality: how
accurate is the U.S. CPI? : Beyond the Numbers : U.S. Bureau of Labor Statistics.
Retrieved July 25, 2014, from http://www.bls.gov/opub/btn/volume-1/consumer-price-index-
data-quality-how-accurate-is-the-us-cpi.htm