How Is Inflation Calculated?

by James & Miel on November 9, 2009 · 0 comments

David from The Liberty Blogger recently raised an interesting point on a post of mine a bit ago regarding discrepancies between the official government inflation rates and some alternative ways of calculating inflation. That piqued my interest in the ubiquitous economic indicator that we all have a general idea of what it means but I for one have been unclear on some of its specifics. Over the next two posts I’ll be discussing inflation. In today’s post I’ll discuss what inflation as we commonly know it is. My next post will discuss some of the criticisms surrounding how inflation is calculated and its political and economic impact.

Inflation is regarded as the general movement of prices of goods and services in an economy over a period of time. It is also intrinsically tied to the idea of “purchasing power” – the number of good and services that can be acquired with a given unit of money. Assuming a stable income level, an increase in inflation is met with a decrease in purchasing power. For example, $5 in 1950 would allow you to purchase more goods and services than $5 in 2009; a decrease in purchasing power. Therefore, the purchasing power of a dollar decreases as prices increase.

Inflation, as we commonly know it, is calculated by measuring changes in the Consumer Price Index. The Consumer Price Index is a value that attempts to quantify the cost impact of a series of goods an services on “typical” urban families. Calculating the CPI is a two-step process. First, Census data is used to select areas in the U.S. where information on the prices of goods and services will be taken. Next, again using the Census data, a sample of around 14,500 families are selected to provide information on the types of goods and services typically purchased and where those goods and services are most commonly obtained. Then each month, analysts from the Bureau of Labor Statistics call or visit those selected retailers to gather information on the goods and services that make up the index, roughly 80,000 carefully selected items.

In addition to price information, information regarding any changes are also noted – most commonly things like reduced packaging or the discontinuation of that good or service. Once all that information is gathered, specialized analysts at the Bureau of Labor Statistics review the information, compiling the national figures while taking into account variations in the products described above. All the numbers for all the goods and services are aggregated into its designated category (including Food and Beverages, Housing, Apparel, Transportation, Medical Care, Recreation, Education and Communication and Other). Each category value is then weighted and combined with the other category to produce the final CPI value.

Of course it’s not that simple, as many different CPI values can be produced. Values can be seasonally adjusted (recalculated for the effects of the season), or restricted to “core” value (removing categories like Food, as they tend to be more volatile), restricted to Wage Earners and Clerical Workers (as opposed to All Consumers), or restricted to a specific region.

In my next post I’ll discuss some criticisms leveled towards this model of inflation. Stay tuned.

Twitter: @michael_dink

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