Inflation: Causes & Effects

The Consumer Price Index (CPI) is a weighted index that tracks the average price of a representative basket of goods and services that a typical household buys. The percentage change in the CPI from one period to the next is the inflation rate.

How the CPI is constructed

Three steps the statistical agency takes.

Step 1: choose the basket. Statisticians survey thousands of households to find out what they actually spend their money on. The basket is then a representative selection: food, rent, transport, energy, clothing, entertainment, services, and many more sub-categories.

Step 2: apply weights. Items are weighted by their share of household spending. Rent and food typically have very large weights; restaurant meals and overseas holidays have smaller weights. So a 10% rise in rent has more impact on the CPI than a 10% rise in cinema tickets.

Step 3: record prices. Statisticians record the price of every item in the basket each month, in many locations. The weighted average is calculated to give the index value.

The basket and weights are updated periodically (usually annually) to reflect changing consumption patterns. New items are added; outdated items are removed.

Calculating the inflation rate

Inflation rate (%) = ((new CPI − old CPI) ÷ old CPI) × 100

Example — CPI rises from 110 to 115.5 over a year.

Inflation rate = (115.5 − 110) ÷ 110 × 100 = 5%

Two slips that lose marks:

• Using absolute differences rather than percentage changes. Just "5.5" without dividing by the old value is the wrong measure.
• Forgetting that CPI is a weighted index. Treating every item as equally important gives a different answer.

Limitations of the CPI

• The "average household" does not exist. The CPI tends to overstate inflation for low-spending households who buy mostly housing and basics, and understate it for high-spending households (or vice versa, depending on which prices are moving).
• The basket cannot capture quality improvements. A laptop today is far more powerful than one from a decade ago at a similar price; the CPI does not always reflect that.
• The CPI may not include owner-occupied housing costs correctly, leading to debates about its accuracy.
• It is backward-looking: the basket reflects past spending patterns, not the basket households would buy at today's prices.