The consumer price index or CPI is a more direct measure than per capita GDP of the standard of living in a country. It is based on the overall cost of a fixed basket of goods and services bought by a typical consumer, relative to price of the same basket in some base year. By including a broad range of thousands of goods and services with the fixed basket, the CPI can obtain an accurate estimate of the cost of living. It is important to remember that the CPI is not a dollar value like GDP, but instead an index number or a percentage change from the base year.
Constructing the CPI
Each month, the Bureau of Labor Statistics publishes an updated CPI. While in practice this is a rather daunting task that requires the consideration of thousands of items and prices, in theory computing the CPI is simple.
The CPI is computed through a four-step process.
The fixed basket of goods and services is defined. This requires figuring out where the typical consumer spends his or her money. The Bureau of Labor Statistics surveys consumers to gather this information. The prices for every item in the fixed basket are found. Since the same basket of goods and services is used across a number of time periods to determine changes in the CPI, the price for every item in the fixed basket must be found for every point in time. The cost of the fixed basket of goods and services must be calculated for each time period. Like computing GDP, the cost of the fixed basket of goods and services is found by multiplying the quantity of each item times its price. A base year is chosen and the index is computed. The price of the fixed basket of goods and services for each comparison year is then divided by the price of the fixed basket of goods in the base year. The result is multiplied by 100 to give the relative level of the cost of living between the base year and the comparison years.
Figure %: Goods and Services Consumed in Country B
For example, let's compute the CPI for...
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