Consumer Price Index: Understanding Cost of Living and Inflation Trends

UPI Study › Courses › Business Essentials › Free lessons › Lesson 2.5 Free with a free account

Consumer Price Index: Understanding Cost of Living and Inflation Trends

Business Essentials · Chapter 2: Economic Systems and IndicatorsSection 2.5 · lesson 13 of 10515 min · free with a free account

← The Business Cycle: Mapping Economic Performance Over TimeNext lesson: Exploring the Importance of International Trade: Functions and Advantages →

Earn 3 college credits for Business EssentialsRecommended for credit by NCCRS · Business 100 · self-paced · one payment, lifetime access
Enroll in Business Essentials · $250 →Download the syllabus (PDF)

In this lesson

Measuring the price level, and what rising prices do to a business.

  • Explain how the CPI is built and read
  • Define inflation, deflation, and disinflation
  • Trace inflation's effects on a business
  • Convert nominal amounts to real terms

Free study notes

Get this lesson's notes by email

The key points and 4 practice questions with answers, in your inbox. One email, free.

One email. Unsubscribe in one click.

Transcript

Everything said in the video, section by section (2,215 words). Read along, or search it.

Economic Systems and Indicators

Consumer Price Index: Cost of Living and Inflation

Your revenue rose this year. Is your business actually growing? You can't answer that without knowing what happened to prices. This section is about measuring prices, and the Consumer Price Index is the standard tool. We'll see how the index is built, read a worked example, and look at its known blind spots. We'll separate inflation from deflation and disinflation, and look at what causes prices to rise. Then we'll trace how inflation reaches a business, through costs, pricing, wages, cash, debt, and contracts. And we'll practice converting money amounts to real terms, so you never mistake higher prices for growth.

The Price Level

Why a Dollar Needs Adjusting

A dollar today doesn't buy what a dollar bought ten years ago. So any comparison of money amounts across time is misleading, unless prices are taken into account. The price level is the average level of prices across the goods and services in an economy. Measuring it means combining the prices of thousands of different items into a single number. For households, the standard tool is the Consumer Price Index, or CPI. It measures the average change over time in the prices urban consumers pay, for a fixed collection of goods and services. In the United States, the Bureau of Labor Statistics compiles it, and publishes it monthly. There are several versions. The best known covers all urban consumers.

Construction

A Weighted Market Basket

The CPI is built around a market basket, a collection of goods and services representing what a typical household buys. Food, housing, apparel, transportation, medical care, recreation, and education are all in it. The Bureau of Labor Statistics decides what goes in, and in what proportions, from studies of how households actually spend their money. Each item is then priced repeatedly, at stores and other outlets across the country. Not every item counts equally. A dollar spent on housing matters more to the average household than a dollar spent on stationery. So each item is weighted by its share of household spending, and the weights are updated as spending patterns change. The prices are then turned into an index number. That's the cost of the basket now, divided by its cost in a base period, times one hundred. The base period is set to one hundred by convention. Choosing it is a matter of documentation, not economics. A reading of one hundred ten means the basket costs ten percent more than in the base period. Ninety would mean ten percent less. But the level isn't what matters for decisions. What matters is the change between two dates. The percentage change in the index from one period to another is the measure of inflation.

Table 2.5.1

A Three-Item Basket

Here's a simplified example, with a three-item basket and made-up figures. The basket holds one hundred loaves of bread, fifty gallons of fuel, and one month's rent. Those quantities never change, so any change in cost comes only from prices. In year one, bread costs two dollars a loaf, fuel four dollars a gallon, and rent six hundred dollars. The basket costs one thousand dollars. In year two, every price rises, and the basket costs one thousand seventy dollars. Divide by one thousand, multiply by one hundred, and the index is one hundred seven. Inflation for year two is seven percent. In year three, fuel falls back to four dollars, while bread and rent keep rising. The basket costs one thousand ninety, and the index is one hundred nine. Now the inflation rate. It's the change from one hundred seven to one hundred nine, or twenty divided by one hundred seven. That's about one point nine percent. Notice two things. The index reports the average of many movements, with fuel going one way and rent another. And rent, with the largest weight, dominates the result. Also, inflation fell sharply, from seven percent to under two, even though the price level kept rising. One more caution. The CPI tracks an average household, not any actual one. A retired household spending heavily on medical care, and a young one spending heavily on rent, will each find their own inflation differs from the average. The index buys comparability over time and place, not precision about any single budget.

Limitations

Where Measured Inflation Drifts

The CPI has known limitations, and the Bureau of Labor Statistics discusses them itself. The first is substitution. When some prices rise, consumers shift toward items whose prices rose less. A fixed basket ignores that shift, so it overstates the cost of living. The second is quality change. If a product improves at the same price, the true price per unit of quality has fallen, even though the label hasn't changed. If quality deteriorates, the reverse is true. Adjusting for either is difficult. Third, new products enter the basket slowly, so the price falls of their early years may be missed. Fourth, outlet substitution. Shoppers move to cheaper stores, and prices sampled at the old outlets miss the saving. Each of these pulls measured inflation away from the true change in the cost of living, in different directions at different times. Statistical methods reduce the errors, without eliminating them. Other price measures are published alongside the CPI. The producer price index tracks the prices domestic producers receive, often an early signal of costs that may later reach consumers. The GDP deflator covers everything produced in the economy, so it's broader than the CPI. A business should pick the measure that matches the prices it actually faces.

Key Terms

Inflation, Deflation, and Disinflation

Inflation is a sustained rise in the general price level. Two words in that definition carry the weight. General means prices across the economy. Suppose a poor harvest raises the price of one crop. That's a relative price change, not inflation, because other prices may be unchanged, or even falling. Sustained means the rise persists. Inflation is prices rising together, and continuing to rise. Two related terms are routinely confused. Deflation is a sustained fall in the general price level. Prices end up lower than before. Disinflation is a fall in the rate of inflation. Prices are still rising, just more slowly. The basket example shows disinflation. Prices rose in both years, but the rate slowed from seven percent to about one point nine percent. No deflation happened at all.

Causes

Why Prices Rise

Economists describe the causes of inflation in categories, and the categories aren't exclusive. Demand-pull inflation happens when total spending grows faster than the economy's capacity to produce. Too much money is chasing too few goods, and prices get bid up. Cost-push inflation happens when the costs of production rise, for example energy prices, or wages. Firms pass the increases on in their prices. Expectations also play a role. If businesses and households expect prices to rise, they act on it. Firms raise their prices, and workers ask for higher wages. And that behavior can make the expectation self-fulfilling. In any particular episode, separating these causes is difficult, and economists disagree about how much weight each deserves. The money supply, as both a cause and a cure, is a subject for chapter twenty-three.

Effects on a Business

Seven Channels of Inflation

Inflation reaches a business through several channels. Input costs rise. Materials, energy, and services all get more expensive, often at different rates. Pricing gets harder. Raise prices too slowly, and your margin is squeezed. Raise them too quickly, and you risk losing customers. Changing prices isn't free, either. Catalogs get reprinted, contracts renegotiated, customers informed. Those are called menu costs, and they're why firms adjust prices in steps, not continuously. Wage pressure builds. Employees whose purchasing power is falling will ask for raises, and a business that refuses may lose staff. Holding cash becomes costly, because idle money buys less each year. Fixed-rate debt gets cheaper in real terms. The borrower repays in dollars worth less than those borrowed, which favors borrowers over lenders. The reverse holds when inflation turns out lower than expected. And contract terms matter. A long-term contract with a fixed nominal price puts the inflation risk on one party, generally the seller. Households feel inflation unevenly, too. Those whose incomes adjust with prices are protected. Those on fixed incomes lose purchasing power. Savers holding cash lose, borrowers with fixed-rate loans gain, and households spending heavily on the fastest-rising items bear more of the burden. Whether that's fair is a normative judgment. How large the effects are, and who bears them, are separate empirical questions.

Real and Nominal

Convert Before You Compare

That brings us to a discipline every manager needs. Convert to real terms before you compare across years. A nominal value is an amount of money, measured in the prices of the period in which it occurs. A real value is the same amount adjusted for price changes, so it measures purchasing power in a chosen base period's prices. To convert, divide the nominal amount by that year's price index, expressed as a proportion of the base year's index. Take a business with nominal revenue of six hundred forty thousand dollars in year five. The index stands at one hundred twenty-nine, against one hundred in year one. Six hundred forty thousand divided by one point two nine is about four hundred ninety-six thousand, in year one dollars. Nominal revenue rose twenty-eight percent over the five years. Real revenue fell slightly. That's a very different story. A business judging itself by nominal revenue would report growth in years when it actually stood still. Indexation builds this adjustment into payments automatically. It appears in contracts as escalator clauses, and in wages as cost-of-living adjustments. Social Security payments are tied by law to a version of the CPI. Indexation shifts inflation risk from the recipient to the payer. A business paying an indexed amount takes on a cost that grows with the index.

Responses

Four Levers, Four Trade-offs

A business has several ways to respond to inflation, and every one carries a trade-off. On pricing, it can pass higher costs on to customers. That protects the margin, but may reduce demand. Or it can absorb the costs, which keeps customers, but reduces profit. On contract terms, it can shorten fixed-price commitments, or include escalator clauses so its price follows its costs. The cost there is that its own charges become less predictable for customers. On inventory, it can buy ahead of expected increases. That locks in current prices, but ties up cash, and risks holding goods that lose value if prices fall. On inputs, it can hedge, fixing the price of important inputs through supplier agreements or financial instruments. That reduces uncertainty, at a cost. Hedging and long-term contracts carry legal, tax, and financial consequences, so a business considering them should get specialist advice. The policy response to inflation, especially the central bank and interest rates, is the subject of chapter twenty-three.

Worked Application

An Escalator Clause

Let's see indexation at work in an escalator clause, with made-up figures. A fabricator agrees to supply a customer with parts for three years, at a base price of one hundred thousand dollars a year. An escalator clause adjusts the price each year by the change in an agreed price index, which stands at one hundred at signing. A year later, the index is one hundred seven. So year two's price is one hundred thousand times one point zero seven, or one hundred seven thousand dollars. If the index then reaches one hundred nine, year three's price is one hundred nine thousand dollars. Notice that each adjustment applies to the base price, using the current index over the index at signing. The percentage changes aren't compounded separately. The clause protects the fabricator, whose own costs are rising. It shifts the risk to the customer, who can no longer budget the price with certainty. A customer might prefer a fixed price instead, and accept that it will start higher, because the seller is charging for the risk it carries. So choosing between fixed and indexed prices is choosing who bears inflation risk. The answer depends on who can better absorb it, and what each expects the index to do. And the choice of index matters. An index of consumer prices may move very differently from the fabricator's actual input costs. Tie the clause to the wrong index, and it protects against the wrong risk.

Case Vignette

Rising Revenue, Falling Volume

Our closing case is a composite, built for instruction, with illustrative figures. Dana owns a specialty food shop. At year end, she sees revenue up eight percent on the year before, and she's inclined to open a second location. But the number of items she sold fell by three percent. She raised her prices during the year, as her suppliers raised theirs. So the revenue increase is a nominal figure. It combines a price effect with a volume effect. In real terms, the volume of business, the true measure of demand for her products, has fallen. A general index like the CPI is a guide to inflation in the economy. The better evidence about her own customers is her unit sales and her own prices. The trade-off is between expanding on a headline number, and waiting for evidence of demand. And she can't yet tell whether the fall in volume is temporary, caused by the price rises, or the start of a lasting loss of customers. So she treats revenue as nominal, looks at units, and delays the second shop until she sees whether volume recovers. That completes chapter two, from the foundations of economics through market structures, output, the business cycle, and prices. Next, chapter three carries the analysis outward, into international business.

About Business Essentials at UPI Study

Business Essentials (Business 100) is a self-paced online course of 105 video lessons in 24 chapters, from the business environment, economics and global markets to ownership, management, leadership, operations, people, marketing, accounting, finance and banking. It carries a NCCRS credit recommendation for 3 semester credits.

Every lesson transcript is free on pages like this one, and the videos are free with a free UPI Study account. Enrolling adds a practice quiz after each lesson, the graded work and final exam that earn the credit, lifetime access, and an official transcript on completion. UPI Study has helped over 130,000 students with college credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Enroll now → Course details Download the syllabus All Business courses Every course with PRO →

Compare: Business Essentials vs Principles of Management

Why take it here

Why students take Business Essentials with UPI Study

How a business works, end to endBusiness Essentials is a survey of how companies work: economic systems, global trade, forms of ownership, management and leadership, operations, human resources, marketing, accounting, finance and the banking system. It is a common first course in business, management and accounting degrees.
Credit at a fraction of the priceThe same 3 credits can cost $750 or more at a US college. Here it is one payment, self-paced, with lifetime access.
Finish your degree soonerTransfer credits reduce the courses you still owe, so you can graduate earlier or lighten a heavy semester.
Strengthen an applicationA completed college-level course on an official transcript shows admissions and scholarship committees you can do the work.
Study on your own scheduleNo start dates, no deadlines. Watch the lessons, practice, and take the final when you are ready.
130,000+students helped with college creditsACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Where the credit goes

Universities that work with NCCRS

Business Essentials carries a NCCRS credit recommendation. These universities work with NCCRS; some are UPI Study's signed partners. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.

Thomas Edison State UniversityThomas Edison State UniversitySigned partnerUniversity of the PeopleUniversity of the PeopleSigned partnerCharter Oak State CollegeCharter Oak State CollegeSigned partnerStrayer UniversityStrayer UniversitySigned partnerColumbia Southern UniversityColumbia Southern UniversitySigned partnerIndiana TechIndiana TechSigned partnerPenn StatePenn StateWorks with NCCRSSouthern New Hampshire UniversitySouthern New Hampshire UniversityWorks with NCCRSSUNYSUNYWorks with NCCRS +many more cooperating universitiesFind my college →

Find my college → Not listed? Ask Athena in the corner of this page, or book a 15-minute call.

FAQ

Questions students ask us

About Consumer Price Index: Understanding Cost of Living and Inflation Trends

What is the Consumer Price Index?
The Consumer Price Index measures the average change over time in the prices urban consumers pay for a fixed market basket of goods and services. The Bureau of Labor Statistics compiles and publishes it monthly. Items such as food, housing, transportation, and medical care are weighted by their share of household spending. The index equals the basket's current cost divided by its base-period cost, times 100.
How do you calculate the inflation rate from the CPI?
The inflation rate is the percentage change in the CPI between two periods: subtract the earlier index from the later one, divide by the earlier index, and multiply by 100. If a basket costing $1,000 in the base year costs $1,070 the next year, the index is 107 and inflation is 7%. If the index then reaches 109, inflation is 2 divided by 107, or about 1.9%.
Why might the CPI overstate the cost of living?
The CPI can overstate changes in the cost of living partly because of substitution: when some prices rise, consumers shift toward items that rose less, but a fixed basket ignores that shift. Quality improvements at the same price, the slow entry of new products, and shoppers moving to cheaper stores can also distort it. Statistical methods reduce these errors but do not eliminate them.
What is the difference between inflation, deflation, and disinflation?
Inflation is a sustained rise in the general price level, deflation is a sustained fall in it, and disinflation is a fall in the rate of inflation while prices are still rising. If inflation slows from 7% to 2%, that is disinflation, not deflation, because prices are still higher than before. A rise in one product's price, such as a crop after a poor harvest, is a relative price change rather than inflation.

About the Business Essentials course

How many college credits is Business Essentials?
Business Essentials (Business 100) carries a NCCRS credit recommendation for 3 semester credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
How much does Business Essentials cost and what is included?
$250, paid once, with lifetime access: all 105 video lessons, a practice quiz after each, the graded work and final exam, and an official transcript when you finish. Students who want several courses choose UPI Study PRO instead.
Which universities accept UPI Study credits?
UPI Study has signed partner agreements with universities such as Thomas Edison State University, University of the People and Charter Oak State College, and works with universities such as Penn State, SNHU and SUNY. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities. Use "Find my college" on this page to check yours.
How long does Business Essentials take?
It is self-paced with no deadlines. The 105 lessons total about 24 hours of video; most students add reading and practice time and finish in a few weeks to a few months, on their own schedule.
How are the exams done?
Quizzes and assignments are online in the course. The final exam is taken online with proctoring; a person on the UPI Study team checks assignments, usually within two days.
How do my credits reach my college?
When the course shows 100% complete, request the official transcript from your dashboard. It is sent to the college you name, and you can send it to more than one. Check your college first with "Find my college" on this page, or ask Athena.

Ready for the full course? Earn 3 credits in Business Essentials.

105 video lessons, a quiz after each one, and the graded work that earns the credit. Recommended for credit by NCCRS.

Enroll in Business Essentials →Download the syllabusEvery course with PRO →
Business Essentials
3 credits · NCCRSEnroll →