Measuring Inflation: How to Calculate and Understand Inflation Rates | CFA Level I Economics
Welcome back as we learn some of the ways to measure inflation. In this lesson, we’ll discuss different methods of calculating inflation rates and understand their limitations.
Consumer Price Index (CPI)
In an economy with a wide array of goods and services, most countries will calculate a Consumer Price Index (CPI) to determine a basket of goods and services that reflect the cost of living of a typical consumer. Each country must determine their own basket of goods and services that best represents the cost of living in their country.
Let’s consider the CPI of Tinyland, a simple economy where the basket of goods is determined as just potatoes, rice, a sedan car, and rent, in the following quantities. The base year is where the CPI is determined to be 100. So assuming these are the prices in the base year, the cost of the basket in the base period is $1870.
When the prices of all the goods increase, and we use the exact composition in the exact quantity as the base year, this price index is known as a Laspeyres index. The CPI is calculated as the cost of the basket at the current price with reference to the cost of the basket at base price.
CPI = (Cost of Basket at Current Prices / Cost of Basket at Base Period Prices) x 100
Shortcomings of Laspeyres Index
There are some limitations with the Laspeyres index where the basket of goods and services is fixed:
- Quality Bias: A Laspeyres index will be upwardly biased if it is not adjusted for quality improvements. Quality bias can be adjusted by a technique known as hedonic pricing.
- New Products: A fixed basket of goods and services will not include new products, creating an upward bias in the Laspeyres index. This bias can be fixed by periodically reviewing consumption habits.
- Substitution Bias: A Laspeyres index can be upwardly biased if it doesn’t account for consumers substituting relatively more expensive goods with relatively cheaper substitutes. To fix this bias, a chained price index like the Fisher index can be used.
A Fisher index is the geometric mean of a Laspeyres index and a Paasche index. A Paasche index uses the current consumption weights and current prices to compute the cost of the basket. This adjusted CPI takes into account that consumers may have substituted relatively more expensive goods with relatively cheaper substitutes.
Alternative Measures of Inflation
Besides the CPI, other important inflation measures include:
- Price Index for Personal Consumption Expenditures (PCE): Unlike the CPI, which is usually based on household surveys, PCE is based on business surveys.
- Producer Price Index (PPI) or Wholesale Price Index (WPI): Reflects the price changes experienced by producers. The PPI can be a predictor of future CPI.
- Headline Inflation and Core Inflation: Headline inflation refers to price indexes for all goods, while core inflation refers to price indexes that exclude food and energy.
- GDP Deflator Index: Many countries publish a GDP deflator index to eliminate the price effect in nominal GDP data, so as to identify trends in real economic growth. Price indexes can often be used to derive this GDP deflator.
And that concludes this lesson on inflation measures. We’ve learned about the different methods of calculating inflation rates, their shortcomings, and how to adjust for biases. In the next lesson, we will explore various economic indicators and how to interpret them. See you again soon!