Consumer Price Index Law and Legal Definition

As the most widely used measure of inflation, the Consumer Price Index (CPI) is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.

The CPI is a method for adjusting income payments. Over 2 million workers are covered by collective bargaining agreements which tie wages to the CPI. The index affects the income of almost 80 million people as a result of statutory action: 47.8 million Social Security beneficiaries, about 4.1 million military and Federal Civil Service retirees and survivors, and about 22.4 million food stamp recipients. Changes in the CPI also affect the cost of lunches for the 26.7 million children who eat lunch at school. Some private firms and individuals use the CPI to keep rents, royalties, alimony payments and child support payments in line with changing prices. Since 1985, the CPI has been used to adjust the federal income tax structure to prevent inflation-induced increases in taxes.

Additional Definitions

Consumer Price Index (CPI)

The Consumer Price Index (CPI), sometimes called the cost-of-living index, measures the average change in prices that typical American wage earners pay for basic goods and services, such as food, clothing, shelter, transportation, and medical care. It is expressed as a percentage of the cost of the same goods and services in a base period. For example, using the years 1982 to 1984 as a base period with a value of 100, the CPI for December 2005 was 198.6, meaning that prices had increased by an average of 98.6 percent over time. The CPI is often used to measure inflation, so it is closely monitored by government policymakers and by individuals whose wages vary with the purchasing power of money. The practice of indexing wages to the CPI is known as a cost-of-living adjustment (COLA). The term "cost of living" is often applied to the numerical result of the CPI. Loosely defined, it refers to the average cost to an individual of purchasing the various goods and services needed to maintain a reasonable living standard.

The U.S. Bureau of Labor Statistics (BLS) began calculating the CPI in 1917, and over the years it has become an important economic statistic. The CPI is calculated monthly and is usually reported within the first two weeks of the following month. In order to calculate the CPI, the BLS surveys about 24,000 households to find out where families shop regularly and what types of goods and services they purchase. It then contacts about 21,000 retail businesses in 85 major metropolitan areas to obtain prices for 90,000 items. All of this information is combined in the CPI, which represents the average price of a "market basket" of goods and services.

The selection of items in the basket can not be held absolutely fixed for a very long period, of course, since the mix of items people buy changes over time. For example, the weight on tobacco in the CPI basket has fallen over the years as the number of smokers in the population has fallen. Personal computers were not part of the CPI in the 1970s but are a part of the basket today. To address these changes in purchasing patterns the BLS tries to incorporate any new developments in the market by changing 20 percent of the retail outlets and items in its survey every year on a rotating basis.

A separate CPI is calculated for different income levels, geographical areas, and types of goods and services. For example, the CPI-U is calculated for all urban households, which includes about 80 percent of the U.S. population. In contrast, the CPI-W measures average price increases for the 32 percent of Americans who derive their primary income as wage earners or clerical workers. The BLS also publishes a CPI for each of seven major categories of items: food and beverages, housing, apparel, transportation, medical care, entertainment, and other goods and services. In addition, it compiles individual indexes for 200 different items and combined indexes for 120 smaller categories of items. Separate CPI measurements are also released for four major geographical regions of the United States—Northeast, North Central, South, and West—as well as 29 large metropolitan areas.

The CPI influences the American economy in several ways. A high annual percentage increase in the CPI reflects a high rate of inflation. The Federal Reserve Board, which controls the nation's money supply, often reacts to such increases by raising interest rates. This makes it more expensive for individuals and businesses to borrow money, which usually slows spending, encourages saving, and helps to curb inflation in the economy. The CPI also determines the percentage of annual increase or decrease in income for many Americans. For example, COLA formulas based on the CPI are built into many employment contracts. The federal government also uses the CPI to adjust Social Security and disability benefits, to determine the income level at which people become eligible for assistance, and to establish tax brackets. In addition, the CPI is often used to compare prices for certain goods within a set of years, and to calculate constant dollar values for two points in time.

Some economists believe that the CPI overstates actual increases in the cost of living by 1 percent or more annually. They generally attribute the discrepancy to some combination of the following four factors: improvements in the quality of goods; the introduction of new goods; substitution by consumers of different goods or retail outlets; and the difficulty of measuring the prices consumers actually pay for goods.

BIBLIOGRAPHY

Boskin, Michael J. "The CPI Commission." Business Economics. April 1997.

"Cost-of-Living Lesson." American Demographics. December 1994.

Reinsdorf, Marshall. "The Effect of Price Dispersion on Cost of Living Indexes." International Economic Review. February 1994.

U.S. Census Bureau, Current Population Reports. Income in the United States: 2002. September 2003.

Hillstrom, Northern Lights

updated by Magee, ECDI