Often in everyday conversations, people talk about how expensive things have become compared to previous years. In reality, how expensive things are? Inflation is simply a rise in price levels, thereby decreasing the purchasing power of consumers. Just like so many consumer products are priced double or triple now compared to say 10-20 years ago. So how do we know how much inflation has increased? This is where Consumer Price Index (CPI) comes into play. CPI acts as a metric and is used to measure inflation. Data is collected on the prices of goods and services that are consumed by the retail population to measure the CPI. It is purely focused on measuring retail inflation.
What is the Consumer Price Index (CPI)?
CPI focuses on the demand side of the economy. It measures the changes in the price level of products consumed by the retail consumer. CPI of any country is calculated for fixed baskets of goods and services. As new products and services keep coming into the market over the years and calculating CPI with new products would not be possible. The ones that are kept in the basket may or may not be altered by the government from time to time depending on the country’s policy.
CPI is a macroeconomic indicator of inflation. It also reflected the overall purchasing power of the country’s currency. For example, Amul paneer used to cost around Rs 170 to Rs 180 for a kg. Now the same paneer in 2022 costs Rs 340. More currency is needed for purchasing the same quantity of goods, thereby reducing the value of the currency. Just like we hear our older generation saying back in their days Rs 10 were a lot. In India, CPI is a vital tool used by the Reserve Bank of India, central government and state governments.
Data is collected on the prices of goods and services that are consumed by the retail population to measure the CPI.
What does CPI reflect?
CPI is a vital economic tool; it highlights several key parameters which are useful for the government to draft policies and take measures accordingly.
The cost of living
CPI measures the change in the prices of consumer goods. As the price of consumer goods and services change, the cost of living would change too. Say if the prices of groceries and everyday essentials has increased, the cost of living has increased too. It reflects the cost of living of consumers in society.
The increased prices of goods and services
CPI helps the government to understand which goods and services have increased their prices, the percentage of rising in prices and the overall pricing graph of the product/service. While higher prices over the years are no surprise for the government, an astonishing steep rise in any product/service is concerning.
Indian rupee’s worth
With CPI, the inflation rate can be calculated and so can the money’s worth be. The government will be able to access the value of the Indian rupee. If the value is declining over time, required measures can be taken.
The purchasing power of consumers
The cost of living and the purchasing power of the consumers can be calculated using CPI. As the cost-of-living increases, the purchasing power is bound to change across various strata of society.
How is CPI calculated in India?
Measuring the price of baskets of goods and services consumed by an average Indian is a strenuous task. As the baskets of goods and services include food, clothing, electricity, transportation, education, medical care and many more. It almost includes anything and everything that requires money.
CPI is calculated by comparing the current price levels in the market to the price levels of a market in the past. The price levels of the previous year are referred to as the base year. The base year here acts as a benchmark for comparing with the current prices. Currently, the base year is considered as 2016. The base year is monitored by the Central Statistics Office (CSO), Programme Implementation (Mospi) and Ministry of Statistics. Changes are made from time to time by these committees.=
In mathematical terms, the formula of CPI is:
Consumer Price Index = (Cost of the market basket in a given year/Cost of the market basket in the base year) x 100
CPI is calculated in percentage. The statistics of CPI are released by the National Statistical Office (NSO). The several items of goods and services in the CPI basket can be broadly divided into several categories. Some of the common categories in the basket are food and beverages, clothing, housing, fuel and light, footwear and recreation. In India, there are five consumer price indexes (CPIs). CPI for Industrial Worker (IW), CPI for Agricultural Labourer (AL), CPI for Rural Labourer (RL), CPI-Urban and CPI-Rural.
The link between CPI and Repo Rates
CPI being a useful economic tool, it helps the RBI as well while drafting the monetary policies for the country. The RBI aims at keeping the inflation rate of the country around 4%. However, it usually fluctuates anywhere between 2% and 6%. RBI aims to establish inflation control and the way it does keeps changing from time to time depending on the decision of the monetary policy committee.
Depending on the inflation, the repo rates are decided. If inflation is rising, it means the prices are rising in general. To bring the rising inflation to halt and potentially reduce it, the central bank would aim to reduce the supply of money in the economy. To reduce the supply of money, the repo rates by RBI are increased. This in turn will increase the interest rate on borrowings from the bank. An increase in the interest rate will help in arresting the liquidity in the economy. Inflation is an important factor in determining the monetary policy of the RBI.
CPI is calculated by comparing the current price levels in the market to the price levels of a market in the past.
The limitations of CPI
CPI is an important economic indicator and provides data that impacts several national decisions. However, as a macroeconomic indicator, it has its limitations.
Difficulty in price measurement
While recording price changes on a huge range of products, difficulties are bound to arise. There are likely to be local variations of different products or price differences in different states. One way this challenge is usually overcome is by taking the average price of the product after serving it from different parts of the country. However, small reductions in the quantity, weight or size of any product in the basket often goes unnoticed.
The lack of innovation
The basket of products and services from which the CPI percentage of a county is derived lacks the consideration of new products and services. As technology and the economy are rapidly changing, many products and services fail to stand the test of time and many new products are introduced in the market. To have a precise CPI percentage, frequent revision of items and weights is needed. Some products need to be added, while others would be eliminated from the basket.
When the CPI is being calculated, one of the biggest hurdles is to decide the range of households to which the CPI is applicable. As different types of households have different products and services, there cannot be one basket that fits all. Income levels of different households determine their spending habits. The CPI index calculated based on the expenditure of an average Indian household will not help in determining the cost of living of the above and below average households in the country.
Outdated base year
One of the biggest drawbacks of CPI is that the base year data may sometimes feel irrelevant and outdated compared to the current year. Also, it is important to select a base year where the prices were relatively stable. Years where due to unforeseen circumstances of severe inflation or deflation should be avoided. For example, the impact of COVID-19 on the economy was devastating around the world. The year 2020 would be an unstable year for taking as the base year for calculating CPI.
Changes and differences in pattern
CPI may have a limitation in its significance. The basket that is used for measuring CPI is only applicable to the base year in reality. For example, if the base year is 2016 and the CPI is being calculated for 2021. The basket will not be the same after five years clearly. As over a period of time, the income of people changes and the pattern of expenditure too. So many things evolve and alter in society in the current year in comparison to the base year.
Apart from inflation and spending power, CPI also impacts the savings and investment of individuals. As a business, if the CPI is indicating a period of inflation or deflation, changes are needed to be made accordingly. For example, in a period of inflation, a strategic move would be to increase your cash reserves. As inflation means a rise in prices and cost of living, the cost of business expenses is likely to sour. Having cash reserves and working capital would help in sustaining the business during the economic crisis.