How is the CPI calculated and what does it measure?

The Consumer Price Index (CPI) is calculated by collecting data on the prices of a basket of goods and services commonly purchased by households. This basket represents the average consumption patterns of urban consumers in a specific country or region. The prices of these items are then compared to a base period, which is typically set as 100.

To calculate the CPI, the following steps are taken:

1. Selecting the basket of goods and services: A representative sample of goods and services is chosen to reflect the typical consumption patterns of households. This basket includes items such as food, housing, transportation, healthcare, education, and entertainment.

2. Collecting price data: The prices of the selected items are collected regularly from various sources, such as retail stores, service providers, and government agencies. These prices are recorded for each period under consideration.

3. Calculating item price changes: The price changes for each item in the basket are calculated by comparing the current period prices with the prices in the base period. This is done using a formula: (Current Price - Base Price) / Base Price.

4. Weighting the price changes: Each item in the basket is assigned a weight based on its relative importance in household spending. These weights are determined through surveys and other data sources. The price changes for each item are then multiplied by their respective weights.

5. Aggregating the price changes: The weighted price changes for all items in the basket are summed up to obtain the overall price change for the period. This is done by adding up the weighted price changes for each item.

6. Calculating the CPI: The CPI is calculated by dividing the overall price change by the sum of the weights. This result is then multiplied by 100 to express the CPI as an index number relative to the base period.

The CPI measures the average price changes over time for the basket of goods and services consumed by urban consumers. It serves as an important indicator of inflation and is used to track changes in the cost of living. The CPI is widely used by policymakers, economists, and businesses to make informed decisions regarding monetary policy, wage adjustments, and market analysis.