Price indexes are used to measure price changes in the economy. By using a price index, one can “combine” the prices of a number of goods and/or services and express in one number the average change for all the prices. The Consumer Price Index, or CPI, is the measure of price change that is probably most familiar to most people. It measures changes in the prices of goods and services commonly bought by consumers. Items on which the average consumer spends a great deal of money—such as food—are given more weight (importance) in computing the index than items such as newspapers, magazines, and books, on which the average consumer spends comparatively less. The index itself is based on a market basket of approximately 400 goods and services. They are weighted according to how much the average consumer spent on these goods and services in a given—or “base”—year. Other price indexes used in the United States include (1) the Producer Price Index, which measures changes in the prices of consumer goods before they reach the retail level as well as the prices of supplies and equipment bought for use by businesses and (2) the GDP Price Deflator, which is the most inclusive index available since it takes into account all goods and services produced.

To construct any price index, some previous period, most usually one year, is selected as the base period. The prices of any subsequent period are expressed as a percentage of the base period. For convenience the base period of any index and its components are practically always set at 100. For the Consumer Price Index, the formula used to measure price change from the base period is:

We multiply by 100 to express the index in percentage form, which also makes the answer easily comparable to the figure of 100 set for the base period. To keep things simple, let’s say an average consumer in our economy buys only three things, as described in the table *Prices of Three Goods Compared with Base Year*. First compute the cost of buying all the items in the base year:

To compute the Consumer Price Index for Year 1, find the cost of buying those same items in Year 1. Try this yourself. Your answer should be $530, i.e., the sum of (30 x $7) + (40 x $5) + (60 x $2). The Consumer Price Index for Year 1 is then equal to ($530/$480) x 100, which equals 110.4. This means that what we could have bought for $100 in the base year costs $110.40 in Year 1. If we subtract the base year index of 100.0 from 110.4 we get the percentage change in prices from the base year. In this example prices rose 10.4% from the base year to Year 1. Remember that the weights used for the Consumer Price Index are determined by what consumers bought in the base year; in the example given we used base-year quantities to figure the expenditures in Year 1 as well as in the base year. The rate of change in this index is determined by looking at the percent change from one year to the next. If, for example, the Consumer Price Index were 150 in one year and 165 the next, then the percent change for that year would have been a price rise of ten percent. This is computed by use of the following formula:

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