Historically speaking, scholars are not completely in agreement as to who created the first price index. Nonetheless, it’s a financial value that we use on an international scale today and without which we couldn’t imagine modern economics. But what is price index and how do you calculate it? This is the question we’re attempting to answer.
The Early Price Index – Origins
As mentioned in the introduction, the origins of the price index are not entirely clear to present-day scholars. As far as its history goes, the earliest signs of someone calculating a price index come from Rice Vaughan, a Welshman who published the book called A Discourse of Coin and Coinage, in 1675. His attempt was at separating the inflation created by importing precious metals from the New World into Spain and the effect generated by the currency debasement.
However, even though Vaughan laid the foundation for considering a price index, the first man to truly set a formula was William Fleetwood, back in 1707. He had already collected hundreds of years’ worth of price data and was able to show for the first time that the value of money and, thusly, of goods, does, in fact, change over the years.
What Is the Consumer Price Index and How Is it used?
The consumer price index or CPI is a measure used to assess how the average prices paid by a household for a particular line of goods and services changes over time. Specialists have split the expenditure items into approximately 200 categories. They are arranged into eight groups. For example, you might have food and beverages or medical services.
The change in the consumer price index is typically a percentage that shows just how much inflation has grown in a definite period. Needless to say, this type of information is both useful and relevant for an entire plethora of reasons. One of the most important areas in which specialists use it is poverty. The Census Bureau uses the consumer price index to analyze to official poverty measure for inflation on a yearly basis.
The consumer price index also shows the spending patterns of the two majors groups of the population. These are the consumers and wage earners based in urban areas and the clerical workers. The latter group includes the professionals as well as the self-employed, the people without a job, and the poverty-stricken. The first group, meaning the all-urban one makes up for approximately 87% of the United States’ population.
Analysts use the consumer price index as an economic indicator and as a way to adjust income payments.
There are different types of consumer prices indexes.
- The CPI-U is the traditional Consumer Price Index for all urban consumers
- The C-CPI-U is the newer model of the CPI-U, and it represents the Chained Consumer Price Index for All Urban Consumers
- The CPI-W is the Consumer Price Index for Urban Wage Earners and Clerical Workers. It’s also a subset of the CPI-U and the population it stands for represents some 32% of the total population of the United States.
How to Calculate the Price Index
The price index is calculated via a mathematical formula. Here are the details as well as the explanation.
To be able to construct a price index, one must first select what is called a ‘base year,’ for example, 2015. You must then select a particular type of goods and services. As per our example, we will choose jeans, dresses, and eggs. You then need to calculate what their value was in your selected base year, 2015, and what their current prices are.
The ratio of the expenditures on the jeans, dresses, and eggs at current prices to the expenditure at the base year of 2015 prices is considered to be the price index. Here is a table showing that.
*the prices are fictional, as is this model.
|Item||Quantity||2015 Price||2016 Price||Exp. In 2015||Exp. In 2016|
|Jeans||10||$10||$12||$ 100||$ 120|
|Dresses||5||$20||$25||$ 100||$ 125|
|Eggs||100||$0.55||$0.55||$ 50||$ 55|
|TOTAL||$ 250||$ 300|
The table also shows the market value of the basket of goods for a household and how it was calculated.
Market basket for 2015 = = (10* $10) + (5* $20) + (100* $0.50) = $100 + $100 +$50 = $250
Market Basket for 2016 = (10* $12) + (5* $25) + (100* $0.55) = $120 + $125 + $55 = $300
*the figures that have an asterisk after them, as such *, represent the quantity of each good added to the household market basket.
Evidently, the volume of goods would change from year to year in real life. Regardless of that, we used the same quantities just to show you how the price changes on a yearly basis as well as the impact it has on a household.
Once we have found out these values, we can proceed to calculate the actual price index. We will do that by dividing the Market Basket price of the year we’re interested in, 2016, by the price of the Market Basket of our base year, 2015. We will then multiply that value by 100. Here is what the formula looks like.
Market Basket for 2016 * 100 = 300 * 100 = 120 = Price Index for 2016
Market Basket for 2015 250
*the price index for your selected base year, in our case 2015, will always be 100. The reason is that you are dividing the Market Basket of that base year by itself, an equation which will always have the result 1. Then you are multiplying that result, 1, by 10, which will always give the value 100 as follows.
Market Basket for 2015 * 100 = 250 * 100 = 100 = Price Index for 2015
Market Basket for 2015 250
At the beginning of 2015, the Bureau of Labor Statistics introduced the first great improvement to the consumer price index in the past 25 years, more of which you can see on the Bureau’s official website. It revolves around a new estimation system for the index itself. It is now a more flexible system on the whole and has other reviewing capabilities. The process of redesigning the price index asked for it to suffer some changes in methodology. Most of them regard the imputation of price changes.