HOW THE CONSUMER PRICE INDEX IS CALCULATED

When the Bureau ~f Labor Statistics calculates the consumer price index and the inflation rate, it uses data on the prices of thousands of goods and services. To see exactly how these statistics are constructed, let’s consider a simple economy in which consumers buy only two goods hot dogs and table shows the five steps that the BLS follows.

TABLE 1 Calculating the Consumer Price Index and the inflation Rate: An Example
This table shows how to calculate the consumer price index and the inflation rate for a hypothetical economy in which consumers buy only hot dogs and hamburgers.

Fix the basket. Determine which prices are most important to the typical consumer, If the typical consumer buys more hot -dogs than hamburgers, then the price of hot dogs is more important than .the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living The Bureau of Labor Statistics sets these weights by surveying consumers and finding the basket of goods and services that the typical consumer buys. In the example in the table! the typical consumer buys a basket’ of 4 hot dogs and 2 hamburgers.

Find the prices. Find”the prices of e~h of the goods and services in the basket for each point in time The table shows the prices , of hot dogs and-hamburgers for 3 different years Compute the basket s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times. The table shows this calculation for each of the 3 years. Notice that only the prices in this calculation change. By keeping the basket of goods the same (4 hot dogs ‘and 2 hamburgers), we are isolating the effects of price changes from the effect of any quantity changes that might be occurring at the same time Choose a base year and compute the index.’ Designate one year as the base year, which is the benchmark against which other years are compared. (The choice of base year is as the index is used to measure changes in the cost of living.) Once the base year is chosen, the index is calculated as follows.

That is, the price of the basket of goods and services in each year is divided by the price of the basket in the base’ year, and this ratio is then multiplied by 100. The resulting number is the consumer price index In the example in’ the table, 2005 is the base year. In this year, the basket of hot dogs and hamburgers-costs \$8. Therefore, the price of the basket in all years is divided by \$8 and multiplied by 100. The consumer price index is 100 in 2005. (The index is always 100 in the base year.) The consumer price index is 175 in 2006. This means that the price of the basket in 2006 is 175 percent of its price in the base year. Put differently, a basket of goods that costs \$100 in the base year costs \$175
in 2006. Similarly, the consumer price index is 250 in 2007, indicating that the price level in 2007 is 250 percent of the price level in the base year  Compute the inflation rate. Use the consumer price index to calculate the inflation rate, which is the  percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows.

In our example, the inflation rate is 75 percent in 2006 and 43 percent in 2007  Although this example simplifies the real world by including only two goods, it shows how the Bureau of Labor Statistics computes the consumer price index and the inflation rate. The BLS collects and processes data on the prices of thousands of goods and services every month and, by following the five fore going. steps, determines how quickly the cost of living for the typical consumer is rising. When the BLS makes its monthly of the consumer price index, you can usually ,hear the number on the evening television news or see it in the next day’s newspaper. In addition to the consumer price index for the overall economy, the BLS calculates several other price indexes. It reports the index for specific metropolitan areas within the country (such as Boston, New York, and  Loss Angeles)’ and for some narrow categories 01 and services (such as food, clothing, and energy). It also calculates the. producer price index (PPI), which measures the cost of a basket of goods and services’ bought by firms rather than consumers. Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the producer price index are often thought to be useful in predicting changes in the consumer price index.

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