IGCSE Economics 0455: How the CPI Measures Inflation and Its Effects

Statisticians in Kestria track the cost of living using the Consumer Prices Index (CPI). The CPI is built from a "basket" of goods and services that a typical household buys, with each item weighted according to how much of a typical household's spending it represents, and the whole basket's cost compared with its cost in a base year, when the index is set to 100.

Kestria's CPI rose from 200 in Year 1 to 214 in Year 2. Over the same period, the CPI of Kestria's main trading partner, Doverth, rose by only 2%.

(a) Explain what is meant by the Consumer Prices Index (CPI), and describe briefly how it is constructed. [3]

(b) Calculate Kestria's rate of inflation between Year 1 and Year 2. [3]

(c) Using your answers, explain the likely effect of the difference between Kestria's and Doverth's inflation rates on the price competitiveness of Kestria's exports to Doverth. [3]

(d) Explain one consequence of Kestria's inflation for workers in Kestria whose wages stay the same in Year 2 as they were in Year 1. [2]

Part (a): What the CPI measures and how it is built

The Consumer Prices Index (CPI) measures the average change over time in the prices of a “basket” of goods and services that a typical household buys.

To construct it, statisticians:

select a representative basket of the goods and services households commonly buy,
give each item a weight based on how large a share of household spending it represents (so a rise in the price of a good households spend a lot on affects the index more than the same percentage rise in a good they barely buy),
record the total cost of this basket regularly, and
compare the cost of the basket in each period with its cost in a chosen base year, where the index is set to 100.

Part (b): Calculating Kestria’s rate of inflation

$\text{Rate of inflation} = \frac{\text{new CPI} - \text{old CPI}}{\text{old CPI}} \times 100$

$\frac{214 - 200}{200} \times 100 = \frac{14}{200} \times 100 = 7\%$

Kestria’s rate of inflation between Year 1 and Year 2 is $\boxed{7\%}$ .

Part (c): Effect on the price competitiveness of Kestria’s exports

Kestria’s prices rose by 7%, well above Doverth’s 2% rise, over the same period. This means goods produced in Kestria have become relatively more expensive compared with goods produced in Doverth. If the exchange rate between the two countries’ currencies stays the same, Kestria’s exports will cost Doverth’s consumers more, in relative terms, than before, making them less price competitive. Consumers in Doverth are therefore likely to buy fewer of Kestria’s exports (switching towards Doverth’s own, relatively cheaper goods instead), which could reduce Kestria’s export sales and worsen its trade position with Doverth.

Part (d): Consequence for workers whose wages stay the same

Even though these workers’ money (nominal) wage has not changed, prices in Kestria rose by 7% over the same period. Because the same amount of money now buys fewer goods and services than before, the real value of their wage, its actual purchasing power, has fallen. This means these workers’ real income and living standards fall, even though the number on their pay slip is unchanged.

Final answers

(a) The CPI tracks the average price of a weighted basket of goods and services a typical household buys, compared with a base year set at 100.
(b) Kestria’s inflation rate $= \dfrac{14}{200}\times100 = \mathbf{7\%}$ .
(c) Kestria’s exports to Doverth are likely to become less price competitive, since Kestria’s prices (7%) rose faster than Doverth’s (2%).
(d) Workers with unchanged money wages suffer a fall in real wages/purchasing power, since the same wage now buys less.