# What is CPI? How to calculate CPI

The Consumer Price Index (abbreviated: CPI) is a basic index that measures the prices of goods and services and shows whether the economy is experiencing inflation or deflation.

## What is Consumer Price Index (CPI)

The Consumer Price Index measures the average price of the basket of goods and services purchased by a typical consumer.

## Characteristics of CPI

According to MarkKobaCNBC, CPI measures costs in the following areas:

 Food and beverages Housing Clothing Means of transport Education and communication Entertainment Medical Services Other goods and services

## Meaning of CPI

The consumer price index is a relative indicator reflecting the trend and volatility of retail prices of consumer goods and services used in the daily life of the population and households. Therefore it is used to track the change in cost of living over time. An increase in CPI means an increase in average price and vice versa.

The volatility of CPI can cause inflation or deflation which in turn depresses an economy. When prices rise uncontrollably, inflation becomes hyperinflation.

Typically on July 10, 1946, a price increase of nearly 350% / day caused hyperinflation in Hungary, thereby making the pengo devalued, becoming the lowest currency unit. (According to Cris Carter – 10 July 1946: Hungary suffers the world’s worst hyperinflation, Money Week).

In addition, the overall CPI decline was due to a decline in aggregate demand, causing deflation and economic recession and unemployment.

## How to calculate consumer price index

Step 1: identify the basket of goods: through investigation, one will determine the typical amount of goods and services that a typical consumer buys.

Step 2: Determine the price: statistic the price of each item in the shopping cart at each time

Step 3: Calculate the cost (in money) to buy a basket of goods by multiplying the quantity by the price of each item and then adding it up.

Step 4: Calculate the consumer price index for the years

Step 5: Calculate the inflation rate

## The relationship between CPI and inflation

CPI can measure the inflation experienced by consumers by what they spend on daily consumption. If the CPI goes up, many will assume that inflation is on the rise. The CPI is used by traders to predict future prices or employers to calculate wages or possibly the Government to determine the increase in social protection funds.

The CPI will be used to measure the inflation rate of a country over a certain period of time. A volatile CPI will help you determine whether the inflation rate is rising or falling. Regardless of whether inflation rises or falls, the most impact on the nation’s economy will be.

It is possible that, in some cases, a falling inflation rate will have a positive impact on the economy. For example, as the popularity of the Internet grows, consumers pay less for phone bills. This will benefit them because the cost for the Internet is quite cheap, can comfortably connect through applications without charge.

Or when prices rise uncontrollably, inflation becomes hyperinflation, causing the currency to devalue seriously and the economy can collapse.

## The problems when calculating the consumer price index

There will be 3 main problems that are aggregated through the calculation of the consumer price index. The nature is that using a fixed basket of goods causes many different problems that limit this index. Specifically:

### CPI does not reflect substitution deviation

The first problem facing the CPI is that it does not reflect the substitution bias. Because this index uses the fixed basket of goods data. A familiar trend in consumer consumption is that when a product, commodity or service has a rapidly increasing and increasing price, they will switch to a lower price. .

So the consumption of these goods is higher than the index of those goods which are increasing in price. This factor will make the calculation of the CPI has evaluated the price higher than actual consumption.

### CPI does not reflect the appearance of new products

Another problem that has been pointed out when calculating the consumer price index is the reflection is not enough, not true for the newly emerging goods. Because of the nature of the CPI using a fixed basket of goods, in case new goods appear, consumers will use a certain currency and buy more products. CPI will not be able to reflect the increasing purchasing power of a currency, so it will value the price higher than it actually is.

### CPI does not reflect changes in the quality of goods

The third problem for the calculation of the CPI is the failure to reflect changes in the quality of a particular commodity. Basically, if a certain product or service increases in price, but the proportional quality also increases, or maybe more, then the same price does not increase.

Usually, the quality of goods tends to increase in quality, but the CPI does not measure this and only exaggerates the price level compared to reality.

In general, all 3 issues above when calculating the CPI will cause the price to be exaggerated, not true. Therefore, when calculating this index should also consider to ensure similarity, although it cannot be absolutely accurate, it ensures objectivity when based on the CPI to evaluate the economy.