Method of calculation

The calculation of the CPI involves a hybrid methodology consisting of two stages:
In the first stage, elementary indices are created to show the price levels of very similar goods in the same area. For instance, there is an elementary index for "sports equipment in Seattle".[11] As of June 2007, there are 8,018 of these elementary indices. (8,018 = 211 * 38, where 211 is the number of categories ("item strata") and 38 is the number of geographical areas considered.)[12] All but a few of the elementary indices are based on geometric means formulas.
In the second stage, the elementary indices are combined to create a number of aggregate indices, including the CPI. (The CPI is an aggregate of all 8,018 basic indices. BLS also computes other aggregates computed uses smaller subsets of the basic indices. For instance, there is an all-items index for Boston, and an all-areas index for electricity.)
These aggregate indices (including the CPI) are calculated using a Laspeyres index computed as:
is the change in price level,
is the price of each good in the first period,
is the quantity of each good in the first period,
is the price of each good in the second period.


Weights of the CPI


The weight (or quantities, to use the above terminology) of an item in the CPI is derived from the expenditure on that item as estimated by the Consumer Expenditure Survey. This survey provides data on the average expenditure on selected items, such as white bread, gasoline and so on, that were purchased by the index population during the survey period. In a fixed-weight index such as the CPI, the implicit quantity of any item used in calculating the index remains the same from month to month.


A related concept is the relative importance of an item. The relative importance shows the share of total expenditure that would occur if quantities consumed were unaffected by changes in relative prices and actually remained constant. Although the implicit quantity weights remain fixed, the relative importance changes over time, reflecting average price changes. Items registering a greater than average price increase (or smaller decrease) become relatively more important.


 Method evaluation


This two-stage method is relatively new. Before 1999, CPI used only Laspeyres indices, measures of the price changes in a fixed market basket of consumption goods and services of constant quantity and quality bought on average by urban consumers, either for all urban consumers (CPI-U) or for urban wage earners and clerical workers (CPI-W). It is argued that Laspeyres index systematically overstates inflation because it does not take into account changes in the quantities consumed that may occur as a response to price changes.
The Laspeyres formula works under the assumption that consumers always buy the same amount of each good in the market basket, no matter what the price. The geometric mean price index formula used to calculate many of the elementary indices, in contrast, assumes that consumers will always spend the same amount of money on a good and shift the quantity they buy of that good based on the price. Critics argue that if due to price increases consumers shift from preferred goods to less preferred goods their standard of living has declined and therefore the geometric mean price formula understates inflation.


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