Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-7
Measuring the
Cost of Living
 Discussion Objective
We look for the answers to these questions:
1. What are the different measures of Inflation?

2. What is the Consumer Price Index (CPI)?

How is it calculated? What’s it used for?
3. What is the difference between Weight Reference Year versus
Price Reference Year in computing CPI?
4. Does CPI represent true Inflation?
 Measuring Inflation
The Consumer Price Index

Consumer price index (CPI) - A measure of the average prices of

goods and services in the economy.

Inflation rate- The percentage increase in the price level from one
year to the next.

BASE YEAR (1999) 2008 2009

EXPENDITURES EXPENDITURES
(ON BASE-YEAR (ON BASE-YEAR
PRODUCT QUANTITY PRICE EXPENDITURES PRICE QUANTITIES) PRICE QUANTITIES)

Eye examinations 1 $50.00 $50.00 $100.00 $100.00 $85.00 $85.00

Pizzas 20 10.00 200.00 15.00 300.00 14.00 280.00

Books 20 25.00 500.00 25.00 500.00 27.50 550.00

Total $750.00 $900.00 $915.00

 Measuring Inflation
The Consumer Price Index

FORMULA APPLIED TO 2008 APPLIED TO 2009

 $900   $915 
  100 = 120   100 = 122
Expenditures in the current year
CPI = 100  
Expenditures in the base year  $750   $750 

 122 − 120 
   100 = 1.7%
 120 
 The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall cost of goods and services bought by a
typical consumer
– Monitor changes in the cost of living over time

• Core CPI
– A measure of the overall cost of consumer goods and services
excluding food and energy

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 How the CPI Is Calculated – 1
1. Fix the basket
– The Bureau of Labor Statistics (BLS) surveys consumers to find
the basket of goods and services bought by the typical consumer
2. Find the prices
– The BLS collects data on the prices of all the goods in the
basket.
3. Compute the basket’s cost
– Use the prices to compute the total cost of the basket.

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 How the CPI Is Calculated – 2
4. Chose a base year and compute the CPI
• Designate a year as base year (benchmark)
CPI = [Basket’s cost in current year / Basket’s cost in base year] ×
100
5. Compute the inflation rate
• Percentage change in the CPI from the preceding period
CPI this year−CPI last year
Inflation rate = × 100
CPI last year

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EXAMPLE 1: Market basket: 10 pizzas, 5 shirts
Price of Price of
year Cost of basket
pizza shirts
2021 $12 $18 $12 × 10 + $18 × 5 = $210
2022 $14 $20 $14 × 10 + $20 × 5 = $240
2023 $16 $22 $16 × 10 + $22 × 5 = $270
Compute CPI in each year (2021 base year)
Inflation rate
2021: 100 x ($210/$210) = 100 114.3 − 100
14.3% = × 100
100
2022: 100 x ($240/$210) = 114.3 128.6 − 114.3
12.5% = × 100
2023: 100 x ($270/$210) = 128.6 114.3

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The typical basket of goods and services in USA

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 Inflation Measures in India
• GDP Deflator is the only measure of inflation that takes into account the
inflation in all the goods and services produced in the economy.
• Consumer Price Index is a weighted sum of prices of a standard basket of
goods and services consumed by a typical domestic consumer.
• Wholesale Price Index is a price index of goods and services that are sold by
producers.
• The WPI measures price changes from the perspective of the seller.
• If producers are receiving higher prices from their sales to wholesalers we can
expect that retailers would have to charge higher prices soon that gets
reflected in a higher CPI.
 Inflation Measurement
• Both the CPI and the WPI are measured using base year quantities as weights.
Price indices that do this are called Laspeyre indices.
• A Laspeyre price index is calculated from a basket of fixed quantities of a
given list of goods. We first calculate the total price of the basket of goods
in the base period. Let the price index in the base period be 100. Then we
calculate the total price of exactly the same basket of goods in a subsequent year
j.
• Next, we compute the ratio of the total price of the basket of goods in period j
divided by the total price of the basket in the base period. The price index in
year j then is this ratio multiplied by 100. It tells us the expenditure that must be
incurred in year j as a fraction of the expenditure in the base year in order that
we may obtain the same bundle of goods as in the base year.

MEASURING A NATION’S INCOME B.S.Misra

 Inflation Measurement in India
• In India, segment specific CPIs, namely CPI (IW), CPI (AL), CPI (RL) are being
compiled regularly, catering to the need of specific population group.
• The Labour Bureau compiles and maintains segment specific three different
series of Index numbers viz. (i). Consumer Price Index Numbers for Industrial
Workers on base 2001=100, (ii). Consumer Price Index Numbers for Agricultural
Labourer on base 1986-87=100, (iii). Consumer Price Index Numbers for Rural
Labourer on base 1986-87=100
• The CPI-UNME with 1984-85=100 was compiled and released by the Central
Statistical Organisation (CSO), Ministry of Statistics and Programme
Implementation.
• CPI-UNME has been discontinued w.e.f. December, 2010 and has been replace
by CPI-urban.
 Measures of Inflation in India
Consumer Price Index Numbers for Industrial Workers
➢ Consumer Price Index Numbers for Industrial Workers on base 2001=100 are
being compiled and maintained by Labour Bureau, Ministry of Labour &
Employment in respect of All-India and 78 constituent centres.
➢ The All-India Index for CPI-IW is a weighted average index of centres’ indices.
These indices are compiled on monthly basis and are released on the last
working day of the succeeding month.
➢ Inflation reflecting change in retail prices of goods and services consumed by
the working population is measured with the help of CPI (IW).
Consumer Price Index Numbers for Agricultural and Rural Labourers
➢ The Labour Bureau is also compiling CPI Numbers for Agricultural and Rural
Labourers separately for 20 States and All-India. These indices are released on
monthly basis by 20th of every succeeding month.
 Wholesale Price Index

• Measure of average change in wholesale price .

• First published from the week commencing 10th January 1942
(Base year 1939).
• WPI has been revised with base years 1952-53, 1961-62, 1970-71,
1981-82, 1993-94, 2004-05.
• Previous series of WPI (Base 2004-05) was launched on
September 2010
• Seventh revision is with base year 2011-12 synchronized with
base year of other important indicators such as GDP, IIP etc was
published in May 2017
 Key Concepts in WPI
1. Definition of Wholesale price
• Price for bulk sale at the first stage of transaction
• Existing formula (WPI Base 2004-05) = Basic Price (ex factory price, ex mine
price or mandi price) + Excise Duty- Trade discount
• New Formula (WPI Base 2011-12)= Basic price -Trade Discount
• New WPI is not influenced by fiscal policy
2. Weighting Structure
• Shows relative importance of an item in a basket based on its availability in the
Indian economy as reflected by Net traded value
• Net traded value = Gross Value of Output + Import – Export
3. Methodology
• Compilation of item level indices based on Geometric Mean
 Commodities Included in WPI

Major 1970-71 1981-82 1993-94 2004-05 2011-12

Group/Group

All
Commodities 360 447 435 676 697
Primary
Articles 80 93 98 102 117
Fuel and
Power 10 20 19 19 16

Manufactured
Products 270 334 318 555 564
 WPI-Weightage Diagram
Major 1970-71 1981-82 1993-94 2004-05 2011-12
Group/Group

All Commodities 100 100 100 100 100

Primary Articles 41.7 32.3 22.0 20.1 22.6

Fuel and Power 8.5 10.7 14.2 14.9 13.2

Manufactured 49.9 57.0 63.7 65.0 64.2

Products
 The New Approach to Capture Inflation
• Earlier CPI numbers do not encompass all the segments of the population in the
country and as such they do not reflect the true picture of the price behavior in
the country.
• It is therefore necessary to compile a CPI which takes into account the
consumption patterns of all segments of the population.
• As such, the CSO started publishing the new series of Consumer Price
Index(CPI) numbers for Rural, Urban and Combined (Rural +Urban) on base
2010 taking all segments of rural and urban population from the month of
January, 2011
• http://mospi.nic.in/Mospi_New/upload/t4_18sep12.pdf
 The New Approach to Capture Inflation
• These indices are available for five major groups namely Food, beverages and
tobacco; Fuel and light; Housing; Clothing, bedding and footwear, and
Miscellaneous.
• CPI (Urban) and CPI(rural) numbers are compiled at State/UT as well as at all-
India level.
• The Price data are collected from selected 1114 urban Markets and 1181 villages
covering all States/UTs through personal visits by field staff of Field Operations
Division of NSO, MoSPI.
 Comparison of weighing diagrams
of CPI in 2010 and 2012 Base
2010 Series of CPI (Weights computed 2012 Series of CPI (Weights computed
on the basis CES 2004-05) on the basis CES 2011-12)
Group Description
Rural Urban Combd. Rural Urban Combd.

Food and beverages 56.59 35.81 47.58 54.18 36.29 45.86

Pan, tobacco and 2.72 1.34 2.13 3.26 1.36 2.38
intoxicants
Clothing and Footwear 5.36 3.91 4.73 7.36 5.57 6.53
Housing - 22.54 9.77 - 21.67 10.07
Fuel and Light 10.42 8.40 9.49 7.94 5.58 6.84
Miscellaneous 24.91 28.00 26.31 27.26 29.53 28.32
Total 100.00 100.00 100.00 100.00 100.00 100.00

Item Coverage: the index covers an average of approximately 299 items although the number varies
from market to market in case of CPI (Urban) and village to village in case of CP I(Rural).
 Weightage of Items in CPI
• The basket of items and their weighing diagrams have been prepared using the
Modified Mixed Reference Period (MMRP) data of Consumer Expenditure
Survey (CES), 2011-12, which is 68th Round of National Sample Survey (NSS).
• This has been done to make it consistent with the international practice of
shorter reference period for most of the food items and longer reference period
for the items of infrequent consumption / purchase. The weighing diagrams of
old series of CPI were based on the Uniform Reference Period (URP9) data of
CES, 2004-05, of the 61st Round of NSS
• With this change in the weighing diagrams to 2011-12, the gap between Weight
Reference Year and Price Reference Year (Base Year), which was six years in
the old series, has now been reduced to six months only. Many methodological
changes have also been incorporated in the revised series to make the indices
more robust.
 Recall Period
• In India, there were two main ways of collecting data: Uniform Reference Period (URP)
and Mixed Reference Period (MRP). Up until 1993-94, the poverty line was based on
URP data. This involved asking people about their consumption expenditure across a
30-day recall period. In other words, the information was based on the recall of
consumption expenditure over the last month alone.
• Since 1999-2000, however, data are being collected according to MRP. Under this
method, data on five less-frequently used items are collected over a one-year period,
while sticking to the 30-day recall for the rest of the items. The low-frequency items
include expenditure on health, education, clothing, durables etc.
• MMRP - Data on expenditure incurred are collected for the items falling under edible oil,
egg, fish and meat, vegetables, fruits, spices, beverages and processed foods, pan,
tobacco and intoxicants during last seven days; clothing, bedding, footwear, education,
medical (institutional), durable goods during last 365 days; all other food, fuel and light,
miscellaneous goods and services including non-institutional medical; rents and taxes
during last 30 days.
 Difference in Weight Structure of WPI and CPI

WPI
1. Based on 697 Commodities
2. Manufactured products
get the largest weight
3. Services are not
included
CPI
1. Based on 299 items
2. Food products get the
largest weight
Services are included.
3. The miscellaneous
group includes services such as
transport, education and health

Inflation based on WPI and CPI may diverge because of the difference in
weight structure of the basket of goods whose price is tracked.

INFLATION B.S.Misra
MEASURING A NATION’S INCOME B.S.Misra
 Measuring Inflation
Is the CPI Accurate?
It is important that the CPI be as accurate as possible, but
there are four biases that make changes in the CPI
overstate the true inflation rate:

• Substitution bias.

• Increase in quality bias.

• New product bias.

• Outlet bias.
 Reasons why the CPI may overstate inflation
Substitution bias: The CPI uses fixed weights, amounts to assuming each month the consumer
purchases the same amount of each product in the market basket.
so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have
fallen.
New Product Bias: As composition of index is changed infrequently, newly introduced goods
whose price fall sharply in the initial years is not captures while computing inflation
Quality Improvement Bias:
Price rise also capture the Quality improvements in the product and allowance for the same
should be made. Increase in prices of the product partly reflect improved quality and partly
pure inflation
Outlet Bias: Purchases from discount stores and internet purchases often at discounted prices
are not reflected in the CPI which is based on price statistics collected from traditional full
price retail stores
 Problems with the CPI – 1
• Substitution Bias
– Over time, some prices rise faster than others
– Consumers substitute toward goods that become relatively
cheaper, mitigating the effects of price increases.
– The CPI misses this substitution because it uses a fixed
basket of goods.
– Thus, the CPI overstates increases in the cost of living.

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 Problems with the CPI – 2
• Introduction of New Goods
– The introduction of new goods increases variety, allows
consumers to find products that more closely meet their
needs.
– In effect, dollars become more valuable.
– The CPI misses this effect because it uses a fixed basket
of goods.
– Thus, the CPI overstates increases in the cost of living.

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 Problems with the CPI – 3
• Unmeasured Quality Change
– Improvements in the quality of goods in the basket
increase the value of each dollar.
– The BLS tries to account for quality changes but probably
misses some, as quality is hard to measure.
– Thus, the CPI overstates increases in the cost of living.

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GDP DEFLATOR VERSUS CPI BASED INFLATION FOR USA, 1965–2022

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