Consumer Price Index
Consumer Price Index (CPI) is a weighted average of the prices of a fixed basket of consumer goods where the weights are assigned on the basis of the share of each good in the average consumer's expenditure. Unlike the GDP deflator whose basket of goods changes every year, CPI is based on the same basket of goods from year to year. The categories of consumer goods and their respective weights used in the construction of CPI in USA are given below.
The CPI is considered an index that best reflects the impact of changes in prices on consumer welfare. But some argue that CPI is biased towards the base year since it keeps the consumption patterns that prevailed in the base year fixed for subsequent years and hence may not fully reflect the impact of changes in prices on consumer welfare. For example, when relative prices change consumers will be substituting a cheaper good for the good whose relative price has gone up. As a result, the actual consumer expenditure at any time might be less than what is used in the construction of the CPI on the basis of the weights that prevailed in the base year. As a result the CPI may exaggerate inflation and overstate the loss in consumer welfare due to inflation. In addition, the CPI does not reflect what is happening to the prices of new goods introduced after the base year. The CPI also fails to make a distinction between a rise in prices resulting from quality improvements and that from inflationary pressure. A more frequent revision of the basket of goods may help address these limitations.