104. Uses for the CPI

Movements in the CPI have a major impact on many business conditions and economic considerations. As noted, the CPI is often viewed as a measure of inflation in the economy. Annual rates of inflation are measured by the percentage change in the CPI from one year to the next. The inflation rate from year to year is

Where CPIt, is the CPI in time period T, and CPIt-1 is the CPI in the previous time period. Table 9.10 shows the CPI for 1986 to 1989 using 1982-1984 as the base.

Table 9.10 - CPI and Inflation Rate for Selected Years

Year	CPI	Inflation Rate (%)
1986	109.6	-
1987	113.6	3.6
1988	118.3	4.1
1989	124.3	5.1
1990	127.2	2.3

The inflation rate for 1987, for example, is

Changes in the CPI are also often taken as a Measure of the cost of living. It is argued, however, that such a practice is questionable. The CPI does not reflect certain costs or expenditures such as taxes, nor does it account for changes in the quality of goods available. Further, the CPI fails to measure other valued items in our economic structure, such as increased leisure time by the average worker or improvements in the variety of commodities from which consumers can choose. Nevertheless, the CPI is often cited in the popular press as a measure of the cost of living.

The CPI is often the basis for adjustments in wage rates, Social Security payments, and even rental and lease agreements. Many labor contracts contain Cost-of-living adjustments (COLAs) which stipulate that an increase in the CPI of an agreed - upon amount will automatically trigger a rise in the workers’ wage levels.

The CPI can also be used to Deflate a time series. Deflating a series removes the effect of price changes and expresses the series in Constant dollars. Economists often distinguish between nominal (or current) dollars and real (or constant) dollars. If a time series, such as your annual income over several years, is expressed in terms of 1982 dollars, that income is said to be real income.

Example 9.3. Assume your money (nominal) income was as shown in Table 9.11.

Table 9.11 – Money and Real Incomes for Selected Years

Year	Money Income, $	CPI (1982-84 = 100)	Real Income, $	Purchasing Power of a Dollar
1986	42,110	109.6	38,421	0.91
1987	46,000	113.6	40,493	0.88
1988	49,800	118.3	42,096	0.85
1989	53,500	124.3	43,041	0.80

In 1986, you actually earned $42,110. It would seem that you are doing quite well financially. Your income increased from $42,110 to $53,500 over that time period. However, prices have been going up also. To obtain a measure of how much your income has really increased, in real terms, you must deflate your income stream. This is done by dividing your money income by the CPI and multiplying by 100. The result is your real income expressed in constant (real) dollars of a given base year.

Thus, Real income is the purchasing power of your money income.

Real income =

You earned $42,110 in 1986, but it was worth only $38,421 in 1982-84 prices. That is, keeping prices constant at the 1982-84 level, you are earning an equivalent of only $38,421. Your constant (real) income based on 1982-84 price levels is $38,421. The difference between $42,110 and $38,421 was consumed by rising prices from 1982-84 to 1986. Your money income rose by $53,500 — $42,110 = $11,390, but your real income went up by only $43,041 — $38,421 = $4,620. If prices had gone up faster than your money income, your real income would have actually decreased.

The purchasing power of your dollar is found to be 100/CPI. For 1986 we have 100/109.6 = 0.91. This means that $1.00 in 1986 would buy what $0.91 would purchase in 1982-84.

Economists commonly deflate gross national product (GNP) to obtain a measurement of the increase in our nation’s real output. Gross national product is the monetary value of all final goods and services produced in our economy. By deflating GNP over time, economists eliminate any increase due to price inflation, and arrive at a measure of the actual increase in the production of goods and services available for consumption. Table 9.12 illustrates that real GNP is found by dividing nominal (or current) GNP by the CPI and multiplying by 100.

Table 9.12 – Nominal and Real GNP (in $ billions)

Year	Nominal GNP	CPI	Real GNP
1986	4,140.3	109.6	3,777.6
1987	4 526 7	113.6	3,984.8
1988	4,864.3	118.3	4,111.8
1989	5,116.8	124.3	4,116.5

Thus, Real GNP measures the value of our nation’s output in constant dollars in some base period. It omits any fluctuation due to changing prices.

Real GNP=

Example 9.4 Describes how indexes can have international implications.

According to Business Week, Eastman Kodak Company was experiencing a problem maintaining accurate records on the amount of exports they sold to European and Eastern markets. Persistent fluctuations in prices and exchange rates made comparisons over time almost meaningless. It was impossible to determine if movements in export levels were due to a change in the actual volume of business or simply a result of instability in the financial world. The company’s inability to gain a full appreciation of its international market made planning and decision making quite tenuous. The company finally decided to index export levels, using prices and exchange rates in a selected base period. In this manner, it was possible for Kodak to get a more realistic picture of their true market position.

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