What is CPI?

CPI stands for Consumer Price Index. It is a metric that helps determine a country’s inflation rate. In essence, it measures a country’s retail inflation rate i.e. the rate at which prices of goods and services used by consumers are rising during a specified period.

The CPI is an economic indicator that consists of a basket of goods and services that are commonly used and consumed by households. The index also reflects the change in purchasing power of a country’s currency.

The CPI data is a key economic indicator used by governments, central banks and businesses. It is expressed in terms of percentage. In India, it is generally calculated on a quarterly basis for a financial year. The Reserve Bank of India (RBI) has projected the CPI rate at 5.3% for Financial Year 2023-24.

Indication

CPI is a macroeconomic indicator which is based on a basket of goods and services that may be adjusted by the government from time to time. Policymakers use this index to determine and maintain the money supply and liquidity in the financial system.

A rising CPI indicates an increase in the cost of living in the economy. It shows that goods and services are getting expensive over time. CPI also signifies the value of an economy’s currency and its purchasing power.

How is CPI calculated?

Now that you have a better understanding of what is Consumer Price Index, let’s move forward to learning its calculation method. CPI compares the market price of a basket of commodities and services from time to time.

The basket includes various products like food, clothing, education, medical care, transportation, and anything else that has daily consumption. All product categories are assigned appropriate weightage in the basket. The National Statistics Office (NSO) collects necessary data for market basket creation.

CPI measures how the prices of these goods and services change over time. It compares the prices of a given year to those of a base year. The base year is the benchmark and is monitored by the Central Statistics Office (CSO) and the Ministry of Statistics and Programme Implementation (MOSPI).

The CPI formula can be expressed as follows:

CPI = Cost of the market basket for the given year x 100%

          Cost of the market basket for the base year

What is the significance of CPI?

CPI is primarily used to determine the country’s present inflation rate. It also gives a fair idea about the rupee’s purchasing power. The Reserve Bank of India (RBI) monitors the economy's CPI rate and determines the country’s monetary policy. The RBI aims to control inflation and keep the CPI at the target of 4% with an upper tolerance limit of 6% and the lower tolerance limit of 2%.

For instance, if the CPI rate in the country is very high, the RBI announces certain monetary measures, and one of them is to reduce the money supply in the country. For this, it will increase the repo rate at which banks borrow funds from RBI. This will increase the cost of borrowing and ultimately tend to reduce liquidity in the system. A lower money supply will reduce demand and in turn, will help in bringing down the inflation rate.

CPI also plays a significant part in determining your investment’s value. It helps you understand if your investment has grown in real terms or not. Let’s say your investment reaps returns at a rate of 4%, and the current inflation rate is 4.7%. In such a scenario, your net investment returns get nullified.

Since CPI is a key indicator of inflation it has an impact on the value of the currency. If the CPI rate is high, the purchasing power of the Indian rupee will decrease, meaning you will be able to purchase lesser goods with the same amount than earlier. Thus, also resulting in depreciation in the value of the Indian rupee.

What are the limitations of CPI?

CPI calculation has its own set of limitations, of which you should be mindful. The limitations are as follows:

• Sampling error – It occurs when the right basket of products and services is not chosen. It could also occur due to improper weightage given to important products.
• Non-sampling error – These errors are associated with price data collection and operational implementation of the calculation method.
• Non-inclusion of energy – One of the biggest limitations of CPI is that it does not include energy in its calculation. Energy has the highest daily consumption and makes up a big part of expenditure for every household.

CPI does not consider any other factors beyond consumer products and services. Government policies also play an important part in determining the country’s inflation and aren’t considered as well. Hence, CPI offers only a myopic view of the country's inflation status.

Bottom line

By now your understanding of CPI meaning would have become much clearer. A lower CPI imprint makes the standard of living affordable for all. CPI is an important indicator of economic performance and offers valuable insight into the state of the economy.

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