Consumer Price Index

Another meaningful economic indicator is CPI – “Consumer Price Index”.

The basic definition of CPI is that it measures changes in the price level of a market basket of consumer goods and services purchased by households.”

The CPI in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

The formula looks daunting, but it is fairly simple.

$CPI = \sum_{i=1}^{n} CPI_i*weight_i$

The daunting part is data collection.   But, this is accomplished by the Bureau of Labor Statistics.

Wikipedia says:

A consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households. The CPI in the United States is defined by the Bureau of Labor Statistics as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”[1]

The CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically. Sub-indexes and sub-sub-indexes are computed for different categories and sub-categories of goods and services, being combined to produce the overall index with weights reflecting their shares in the total of the consumer expenditures covered by the index. It is one of several price indices calculated by most national statistical agencies. The annual percentage change in a CPI is used as a measure of inflation. A CPI can be used to index (i.e., adjust for the effect of inflation) the real value of wages, salaries, pensions, for regulating prices and for deflating monetary magnitudes to show changes in real values. In most countries, the CPI is, along with the population census and the USA National Income and Product Accounts, one of the most closely watched national economic statistics.

The Consumer Price Index is used to determine the Rate of Inflation.  This can determine the price of goods, services, housing, employee pay increase, interest rates, pensions, etc.

Example:

Let us say you are employed.  You have your annual performance review and your supervisor praises your job performance over the last year.  Your supervisor then tells you that you have hit the top of the salary schedule for your position. You will, however, receive a cost of living increase.  The supervisor says it will be an increase based the annual rate of inflation.  You should know that this is not a current factor.  It is based on previous years’ indexes.  Anyway.

What can you expect from this news from your supervisor?

Your current salary is $60,000 per year. You receive a paycheck every two weeks, which is 26 times a year. Therefore, your current paycheck is$2,307.69.  The rate of inflation according to the Bureau of Labor is stated as 1.75%.

Your $2,353.85. Congratulations, you just got a$46.16 raise in your paycheck based upon the inflation rate.

You need to understand that the pay raise you just received does not increase your cash flow.  Remember that Cash Flow = Income less Expenses.  The reason your paycheck increase does not increase your cash flow is that the rate of inflation also increases the expenses side of your financial statement.  Therefore you have only maintained your cost of living.  Don’t despair – you did not lower your cash flow.