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What Is The Consumer Price Index And Why Does It Matter?

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Published Date: 14 May 2024Updated Date: 10 Jun 20246 mins readBy MOFSL
CPI

Introduction

Consumer price index, or CPI, is one of the most widely used terms in financial markets. It’s a vital index that measures inflation. It collects data on the most commonly used goods and services that the country’s retail population consumes, tracks their price changes and computes the inflation rate.

Meaning of CPI

CPI, also known as a market basket, measures the price change of goods and services widely used by retail consumers. These consumers are mostly on the economy’s demand side; therefore, CPI is also a measure of the purchasing power of the currency of a particular economy. The basket that CPI uses to calculate inflation may change over time. It generally includes food, medicine, housing, electronics, clothing, etc.

How is CPI calculated?

CPI calculation is a simple process. It measures the changes in the cost of goods and services by accounting for their costs prevalent during a similar period last year. A higher CPI is an indication of high inflation and vice versa. The formula for CPI is:

CPI = (Cost of the basket in a given year / Cost of the basket in the base year) X 100

The base year is the benchmark, and price changes are expressed in percentage relative to the base year. In India, the Central Statistics Office monitors the base year, and currently, it’s 2012.

Why does CPI matter?

Given below are the reasons as to why CPI matters for the commoner and the economy in general:

  • Reflects purchasing power

CPI is crucial for individuals as it reflects their purchasing power and the cost of living. A high CPI indicates inflation, which means lower purchasing power for individuals. In other words, a high CPI reduces the money’s purchasing power. When it’s known, people can effectively plan their budgets.

  • Inflation measurement

CPI is a key inflation indicator. Economists, policymakers and businesses use it to analyse overall price trends in the economy. Monitoring inflation is essential for making informed decisions on fiscal and monetary policies.

  • Wage adjustments

Several organisations plan their contracts and agreements with employees and adjust wages based on changes in the CPI. This ensures fair compensation for workers and helps them maintain a stable living standard despite high prices.

  • Social security and pension payments

Several social security benefits and pension payments are linked to the CPI. Adjusting them based on CPI helps individuals and retirees living on fixed incomes keep up with the rising living costs. It also ensures they are not lacking basic amenities due to high prices.

  • Investment planning

This is another reason why CPI matters. As an investor, you can consider inflation while making your investment decisions. A high CPI may lead to adjusting investment portfolios in a manner that helps you hedge against the impact of inflation on the actual value of money.

  • Economic stability

A stable CPI goes a long way in contributing to economic stability. In case of excessive inflation, the same may affect consumers’ confidence and lead to uncertainty in financial markets. This can disrupt the function of the economy and lead to chaos.

  • Business planning

Businesses use CPI to adjust their pricing strategies and make decisions about their production and investment. Understanding how prices are changing in the broader economy helps businesses plan their future and allows them to remain competitive. 

Limitations of CPI

While CPI is an essential economic metric, it has certain limitations. The limitations include:

  • Substitution bias

CPI assumes consumers don’t change their spending habits in response to price changes. However, in reality, consumers often substitute one good for another if there’s a significant rise in the price of one. CPI often fails to capture these substitutions accurately.

  • Regional variations

The cost of living can vary between regions. However, CPI provides a national average. Note that people in different areas may experience inflation differently. Therefore, CPI may not accurately reflect regional differences.

  • Intangible goods and services

CPI may not adequately account for price changes in intangible goods and services such as education and healthcare. Here, prices rise faster than the average inflation rate.

Summing it up

To conclude, the CPI measures the price change of goods and services widely used by retail consumers. Being the foundation for any transaction, the CPI plays a crucial role for businesses and individuals in every walk of life. It also helps in deciding the value of money.

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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