Macroeconomic Principles: The Consumer Price Index

1 Macroeconomic Principles The Consumer Price Index (CPI) is widely considered one of the most fundamental and critical economic indicators for measuring inflation. However, despite being popularly used as a measure of inflation, the CPI is far from perfect due to a variety of inherent weaknesses. First, the CPI fails to factor in the effects of substitution as it does not change to reflect consumer reaction to changes in relative prices. Similarly, CPI does not capture novelty and innovation as it fails to capture the introduction of new goods quickly. The third problem with the use of this economic indicator is that it does not account for the quality difference in similar goods. If the quality of a product deteriorates from one year to another, its value diminishes even if its price does not change. The CPI fails to take such changes into account by default.

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2 The substitution bias, failure to capture new goods, as well as unmeasured quality changes may cause the index to exaggerate the true cost of living. Due to such measurement problems, the Consumer Price Index overstates a country’s annual inflation rate by approximately one percent. Furthermore, the CPI lacks individual relevance hence may not give accurate inflation levels experienced by an individual due to the fact that it measures price level and inflation with reference to a typical consumer. In other words, if an individual’s spending patterns do not match the average consumer, the figures reported by the consumer price index may not necessarily be of relevance to that individual. Despite the wide use of CPI in measuring the cost of living, it is equally important to recognize its associated drawbacks or limitations.

3 Reference Meyer, D. F., & Habanabakize, T. (2018). Analysis of Relationships and Causality between Consumer Price Index (CPI), the Producer Price Index (PPI) and Purchasing Manager’ s Index (PMI) in South Africa. Journal of Economics and Behavioral Studies, 10(6 (J)), 25-32.