Addendum to Frequently Asked Questions
- The CPI is the most widely used measure of inflation
and is sometimes viewed as an indicator of the effectiveness of
government economic policy. It provides information about price changes
in the Nation's economy to government, business, labor, and
private citizens and is used by them as a guide to making economic
decisions. In addition, the President, Congress, and the Federal Reserve
Board use trends in the CPI to aid in formulating fiscal and monetary
policies.
- The CPI and its components are used to adjust other
economic series for price changes and to translate these series into
inflation-free dollars. Examples of series adjusted by the CPI include
retail sales, hourly and weekly earnings, and components of the National
Income and Product Accounts. An interesting example of this is the use
of the CPI as a deflator of the value of the consumer's dollar to find
its purchasing power. The purchasing power of the consumer's dollar
measures the change in the value to the consumer of goods and services
that a dollar will buy at different dates. In other words, as prices
increase, the purchasing power of the consumer's dollar declines.
- The CPI is often used to adjust consumers' income
payments (for example, Social Security) to adjust income eligibility
levels for government assistance and to automatically provide
cost-of-living wage adjustments to millions of American workers.
As a result of statutory action the CPI affects the income of about 80 million persons:
the 51.6 million Social Security beneficiaries, about 21.3 million
food stamp recipients, and about 4.6 million military and Federal Civil
Service retirees and survivors. Changes in the CPI also affect the cost
of lunches for 28.4 million children who eat lunch at school, while
collective bargaining agreements that tie wages to the CPI cover over 2
million workers. Another example of how dollar values may be adjusted is
the use of the CPI to adjust the Federal income tax structure. These
adjustments prevent inflation-induced increases in tax rates, an effect
called bracket creep.
- Traditionally, the CPI was considered an upper bound
on a cost-of-living index in that the CPI did not reflect the changes in
buying or consumption patterns that consumers would make to adjust to
relative price changes. The ability to substitute means that the
increase in the cost to consumers of maintaining their level of
well-being tends to be somewhat less than the increase in the cost of
the mix of goods and services they previously purchased.
Since January 1999, a geometric mean formula has been used to
calculate most basic indexes within the CPI; in other words, the prices
within most item categories (for example, apples) are averaged with the use of a
geometric mean formula. This improvement moves the CPI somewhat closer
to a cost-of-living measure, because the geometric mean formula allows for a
modest amount of consumer substitution as relative prices within item
categories change.
Because the geometric mean formula is used only to average prices
within item categories, it does not account for consumer substitution
taking place between item categories. For example, if the price
of pork increases relative to the prices of other meats, shoppers might shift
their purchases away from pork to beef, poultry, or fish. The traditional CPI
formula did not reflect this type of consumer response to changing
relative prices. In 2002, as a complement to the CPI-U and CPI-W, the Bureau
produced a new index called the Chained CPI-U (C-CPI-U). The C-CPI-U was created
to more closely approximate a
cost-of-living index by reflecting substitution among item categories.
It is unlikely, however, that the difficult problems of defining living
standards and measuring changes in the cost of their attainment over
time will ever be resolved completely.
It is important to note that area CPIs cannot be used to
compare levels of living costs or prices across areas. (See answer to
Question 18: "Can the CPIs for individual areas be used to compare
living costs among areas?")
- For example, if you or your family spend an average
share of your budget on medical expenses, and medical care
costs are increasing more rapidly than the cost of other items in the CPI market
basket, your personal rate of inflation (or experience with price
changes) may exceed the increase in the CPI. Conversely, if you heat your home with solar
energy, and fuel prices are rising more rapidly than other items, you
may experience less inflation than the general population does. A national
average reflects all the ups and downs of millions of individual price
experiences. It seldom mirrors a particular consumer's experience.
- Data from the Consumer Expenditure Survey conducted
in 2001 and 2002, involving a national sample of more than 30,000
information families, provided detailed information on respondents' spending habits. This
enabled BLS to construct the CPI market basket of goods and services and
to assign each item in the market basket a weight, or importance, based
on total family expenditures. The final stage in the sampling process is
the selection of the specific detailed item to be priced in each outlet.
This is done in the field, using a method called disaggregation. For
example, BLS economic assistants may be directed to price "fresh whole
milk." Through the disaggregation process, the economic assistant
selects the specific kind of fresh whole milk that will be priced in the
outlet over time. By this process, each kind of whole milk is assigned a
probability of selection, or weight, based on the amount the store
sells. If, for example, vitamin D, homogenized milk in half-gallon
containers makes up 70 percent of the sales of whole milk and the same
milk in quart containers accounts for 10 percent of all milk
sales, then the half-gallon container will be seven times as likely to
be chosen as the quart container. After probabilities are assigned, one
type, brand, and size container of milk is chosen by an objective
selection process based on the theory of random sampling. The particular
kind of milk that is selected by disaggregation will continue to be
priced each month in the same outlet.
In sum, the price movement measurement (see Question 8) is
weighted by the importance of the item in the spending patterns of the
appropriate population group. The combination of all these factors gives
a weighted measurement of price change for all items in all outlets, in
all areas priced for the CPI.
- Some examples of technical or statistical
guidelines from BLS follow:
The following illustration shows that although Area B
has higher prices than Area A, the price change in Area A has been
greater than in Area B.
Base Period Current Period
Price Index Price Index
Area A $0.30 100 0.55 183
Area B 0.60 100 .90 150
The CPI thus measures the rates of change in prices, rather than the level of prices.
Last Modified Date: March 28, 2005
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