Inflation is a critical measure of the economy’s health. Rising inflation makes products and services pricy and pulls down the value of the domestic currency. The government keeps a close eye on domestic inflation and implement policies to keep it under a manageable range. But, how do we measure inflation? that is where the Consumer Price Index or CPI comes into the picture.
Now, what is CPI?
The CPI index is a metric to quantify inflation. It is calculated by tracking the change in the prices of essential products and services consumed by households over a period of time. The consumer price index captures the inflation in a fixed set of items like transportation, food, medical care, education, etc. at the retail level.
To understand CPI meaning, it is important to know the methodology behind it. The basic building block of the CPI index is a basket of goods and services. After the items in the basket are finalised, the tracking of the prices is initiated.
It’s the weighted average of a selected basket of goods. Analysts track price change of each of the items in the basket and then compare it with a base year price to determine CPI. Why is it important? Because it affects the life of the people and their purchasing power in the economy. CPI is a widely used statistical measure to identify periods of inflation or deflation.
CPI serves the same purpose at the retail level what WPI (wholesale price index) does at the factory gate. Experts study both to understand how product price changes from the time it is manufactured and by the time it reaches to the end customer.
Different countries use a different basket of goods to calculate CPI and also different base periods, like in India, CPI is calculated against the year 2012.
The base period refers to the year zero from which CPI calculation starts. It has given the value 100. Goods prices are then calculated against the base period.
Key Takeaways
– The CPI is a standard measure that calculates average cost that consumers pay for a basket of goods
– CPI is a statistical measure widely used to compute inflation and study effectiveness of government policy
– Inflation impacts different section of the society differently, and so, different CPIs are calculated like CPI-W is the price index for wage earners, and CPI-U is the price index for the urban consumers
– It is useful for studying the impact of inflation on different economic classes
How is CPI calculated?
Just like the Wholesale Price Index, the CPI too is calculated with reference to a base year. CPI can be easily calculated by dividing the cost of the basket of items in the current year with the price in the base year and multiplying the result with 100. The annual percentage change in CPI is used to assess inflation.
Now, if you are a math geek, here is the formula to calculate CPI.
CPI= Cost of Market Basket in Given Year/ Cost of Market Basket in Base Year×100
Calculating CPI is a rigorous task.
In India, the agency estimates the price of 697 goods to determine CPI.
How Is CPI Measured In India?
India is a diverse country, and due to supply-side disparities, a product’s price may see a higher rise or decline in a rural area than an urban area. For instance, let’s say there is a shortage of onions in the country. The concept of demand-supply dictates the price of onions will rise by certain percentage points.
The rise in price due to low production will be the same across the country. But some far-flung rural areas may see a higher increase in price due to the inefficiency of supply chains, which get aggravated when quantities decline.
The change in the price of the basket of goods and services is tracked at the rural, urban and pan-India level to get a balanced idea. Additionally, different products and services are assigned different weights in the basket. A product can also have different importance based on whether we are measuring rural or urban CPI. For example, food and beverages have 54.18 percent weight in rural CPI but carry only 36.29 percent weight at the urban level.
It is a highly dynamic metric, and it is quite a task to calculate the consumer price index. For convenience and better clarity over price movements, different CPI is computed on different products’ clusters.
Various series of the CPI is released. These are CPI for Industrial Workers (IW), CPI for Agricultural Labourers (AL), CPI for Rural Labourers (RL), and CPI (Urban) and CPI (Rural). The Labour Bureau compiles CPI (IW), CPI (AL) and CPI (RL), while the CPI (Urban) and CPI (Rural), which have a wider population coverage, are compiled by the CSO. These bodies are responsible for the compilation of data, but the collection of data requires extensive work. Field investigators fan to every corner of the country to collect data on price fluctuation from rural and urban areas.
The reason to calculate separate CPIs is to get clarity on the impact of inflation on different income sections. In a country like India with wide income disparity, it gives crucial insight to policymakers to measure the effects of monetary policies in common people’s lives.
What is the importance of the CPI index?
Inflation can have a wide-ranging impact on the livelihood of the people in a developing country like India. CPI is a measure of inflation at the retail level, which means it gives a clear idea of the price rise for the common citizen.
It is a crucial metric to ascertain the cost of living in the country and provides vital pointers to the policymakers. The Reserve Bank of India uses the CPI index as a major metric for the formulation of the monetary policy. The Monetary Policy Committee has set itself a target of maintaining the inflation within a band of 2 -6 percent.
CPI Vs WPI
WPI or wholesale price index is another important measure of inflation. it is important to discuss WPI here because both CPI and WPI help in determining inflation and impact on the livelihood of the people.
Calculation of WPI involves determining product price change at the factory gate. It considers three factors with different weights assigned to each.
– Manufacturing product which carries 65 percent weight
– Primary articles 20 percent, and
– Fuel and power 15 percent
The new WPI basket includes 697 items revised from 676. The base year is also revised from 2005-2006 to 2011-12.
CPI, on the other hand, measures inflation in product price at the hand of consumers. There is a debate on which one gives a fair picture of inflation in the economy. Some economists argue that WPI carries more weight since it measures price inflation at the production level. But both WPI and CPI are used side-by-side to measure the impact of inflation on different income segments in the economy and the effectiveness of government policies.
The consumer price index is also used to determine the dearness allowance of government employees. It helps in understanding the real value of wages and salaries and the purchasing power of the currency.
Conclusion
CPI gives a better glimpse of changes in the purchasing power of the consumer. Recently, The Central Statistical Office (CSO) changed the methodology of calculating CPI to make it more inclusive and robust. They have also changed the base year from 2010 to 2012 and incorporated changes in calculating the series from average method to the geometric mean, which will align it better with the international practices.
