EIN | Inflation & Consumer Price Index

Inflation or Deflation

In our discussion on nominal gross domestic product (GDP) and real GDP, we mention the GDP deflator as a tool that help us measure overall price movements in any economy including our hypothetical economy, Dateland.

Since the GDP deflator is about measuring overall price movements of the goods and services domestically produced, at a first glance, one might think that it might be also a good measure of the overall cost of living of the citizens of the country.

Unfortunately, it is not! There are several reasons that the GDP deflator is not a proper measure of cost of living.

01/03

First, the GDP deflator includes all the goods and services produced within the borders of a country, in our narrative, Dateland.

However, the GDP deflator does not take goods and services imported into account.

If, for example, there has been no change in prices of goods and services produced in Dateland in a year but significant increases in prices of goods and services imported in the same period, GDP deflator will not change, i.e., it will have the same index number at the beginning of the year and at the end of the year.

Thus, it will fail to capture the increase in the cost of living caused by price hikes in imported goods and services

02/03

Second, not all goods counted in GDP are consumed by the citizens of Dateland. If, for example, Dateland is producing firetrucks, a citizen of Dateland most probably will not consume this good.

As a result, even if the price of a firetruck declines this year (assuming that prices of all other goods and services do not change), a typical Dateland citizen’s (Datelander) cost of living will not be affected by this change even though a measurement done by using the GDP deflators at the beginning and the end of the year indicate a decline in the overall price level.

02/03

Third, one can consider the GDP deflator as the price of a gigantic basket including all the goods and services produced within the borders of Dateland. The value proportion of each good (or each service) in this basket most probably would not be the same as the value proportion of that good in a typical Datelander’s consumption basket. For example, in Dateland, only 1% of its GDP, in a given year, consists of dairy products, whereas a typical Datelander’s annual budget, dairy products might constitute 20% of the spending. Thus, the effect of an increase in the prices of dairy products on the cost of living would be underestimated by the change measured by using the GDP deflator.

Therefore, economists had to construct a better measure than that of the GDP deflator to measure changes in the cost of living as accurately as possible.

In the early years of the 20 th century (around 1919), they did! It is called consumer price index (CPI). CPI is a metric of the overall cost of the goods and the services purchased by a representative consumer.

Let’s assume that Dateland Statistical Agency (DSA) is responsible for constructing consumer price index.

Example: Calculation of the Consumer
Price Index and the Inflation Rate

first phase

as it has been mentioned above, The DSA decides that in the CPI market consists of 50 kilograms of Ajwa dates and 365 liters of milk.

Second Phase

The DSA collects the market prices of each good and service included in the CPI market basket for each year of interest

Year	Price of Ajwa dates (per kg)	Price of Milk (per liter)
2019	8 SAR	6 SAR
2020	4 SAR	7 SAR
2021	6 SAR	7 SAR

Third Phase

the cost of the basket of Goods for each year is calculated by the DSA.

Year	Cost of the CPI Market Basket
2019	8 SAR x 50 kilograms of Ajwa dates + 6 SAR x 365 liters of milk = 2,590 SAR
2020	8 SAR x 50 kilograms of Ajwa dates + 6 SAR x 365 liters of milk = 2,590 SAR
2021	8 SAR x 50 kilograms of Ajwa dates + 6 SAR x 365 liters of milk = 2,590 SAR

Fourth Phase

the DSA chooses 2019 as the base year and calculates the CPI in each year by
using the following formula:

(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝐶𝑃𝐼 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 / 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝐶𝑃𝐼 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟)
× 100

Year	CPI Index
2019	$\frac{2, 590 S A R}{2.590 S A R} \times 100 = 100.0$
2020	$\frac{5, 755 S A R}{2, 590 S A R} \times 100 = 106.4$
2021	$\frac{2, 855 S A R}{2, 590 S A R} \times 100 = 110.2$

Fifth Phase

the DSA calculates the inflation rate for each year using the following formula:

C𝑃𝐼 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 −𝐶𝑃𝐼 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟
𝐶𝑃𝐼 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟
× 100

Year	Inflation Rate
2020	$\frac{106.4 - 100}{100} \times 100 = 6.4 %$
2021	$\frac{110.2 - 106.4}{106.4} \times 100 = 3.6 %$

Even though for simplicity we calculated the CPI numbers annually most commonly the CPI numbers are published monthly.

In other words, responsible agencies estimate monthly inflation from monthly CPI numbers. Furthermore, agencies also publish annualized inflation figures based on the monthly inflation – a month’s CPI number compared to the CPI number of the same month in the previous year.

For example, General Authority for Statistics – Kingdom of Saudi Arabia recently published the following CPI Index figures (base year 2018):

Date	GDP Deflator
July , 2021	104.45
June 2022	106.66
July 2022	107.20

From this data, the monthly inflation rate in July 2022 is 0.51% relative to June 2022 [ $\frac{110.2 - 106.4}{106.4} \times 100 = 3.6 %$ ]. On the other hand, the annual inflation rate between July 2021 and July 2022 is 2.63% [ $\frac{107.20 - 104.45}{104.45} \times 100$ ].

Agencies also calculate the CPI numbers for different cities/regions, knowing that the cost of living is not the same across the regions of the country under consideration. For example, the General Authority for Statistics – Kingdom of Saudi Arabia publishes monthly CPI figures for sixteen (16) cities as well as a single CPI figure for “all cities” category as an average.

Agencies also calculate the CPI numbers for different population groups. For example, U.S. Bureau of Labor Statistics estimates the CPI numbers for two population groups, All Urban Consumers (CPI-U) covering approximately 93 percent of the total population and for Urban Wage Earners and Clerical Workers (CPI-W) covering 29 percent of the population.

CPI is not a Perfect Measure of Cost of Living/Inflation

CPI is not a perfect measure of cost of living/Inflation because of three reasons:

01 substitution bias
02 introduction of new goods and services
03 unmeasured quality change

01

Substitution Bias

As we have mentioned above the CPI is based on the fixed basket in that items included in the basket have constant weights in a given time period, say, four years.

This fixity in quantities of the items in the basket creates what economists call substitution bias. In a world of two goods, Ajwa dates and milk, when the price of milk increases, economics predicts that consumer switches from milk to dates to satisfy their calorie needs if the price of Ajwa dates does not change (or even it falls).

However, the CPI ignores this possibility and thus it overestimates the effect of the increase in the price of milk on the cost of living, i.e., inflation.

02

Introduction of New Goods and Services

When new goods and services are introduced, the effect of this introduction on the cost of living cannot be captured by the CPI.

For example, a new agricultural technology enables household to grow their own Ajwa dates at home in a pot in that they can harvest date fruits all year round.

The convenience and the cost savings associated with this new technology are not captured by the CPI because of the fixity until the DSA

03

Unmeasured Quality Change

When the quality of a good changes, say, in the positive direction, unless our hypothetical statistics agency of Dateland, DSA, makes an adjustment to take this change into consideration, the CPI cannot measure the effect of this alteration in the quality on the cost of living.

For example, in the very recent year a new technology increases the quality of milk produced in a way that the new milk is much more nutritional that that of the milk produced in previous years.

Without the necessary adjustment, the increase in the price of the milk due to the increase in its quality cannot be captured by the CPI. In fact, since measuring quality is a highly challenging task, the CPI will always have this problem even if the DSA makes all the efforts to measure the quality.

Economic concept

Services

Country Analysis

Qatar

Saudi Arabia

United Arab Emirates

Inflation or Deflation

Let’s assume that Dateland Statistical Agency (DSA) is responsible for constructing consumer price index.

first phase

Second phase

Third phase

Fourth phase

Fifth phase

Example: Calculation of the Consumer
Price Index and the Inflation Rate

first phase

Second Phase

Third Phase

Fourth Phase

Fifth Phase

Even though for simplicity we calculated the CPI numbers annually most commonly the CPI numbers are published monthly.

CPI is not a Perfect Measure of Cost of Living/Inflation

Substitution Bias

Introduction of New Goods and Services

Unmeasured Quality Change

Qatar

Saudi Arabia

United Arab Emirates

Qatar

Saudi Arabia

United Arab Emirates

Economic concept

Services

Inflation or Deflation

Let’s assume that Dateland Statistical Agency (DSA) is responsible for constructing consumer price index.

first phase

Second phase

Third phase

Fourth phase

Fifth phase

Example: Calculation of the Consumer Price Index and the Inflation Rate

first phase

Second Phase

Third Phase

Fourth Phase

Fifth Phase

Even though for simplicity we calculated the CPI numbers annually most commonly the CPI numbers are published monthly.

CPI is not a Perfect Measure of Cost of Living/Inflation

Substitution Bias

Introduction of New Goods and Services

Unmeasured Quality Change

Qatar

Saudi Arabia

United Arab Emirates

Example: Calculation of the Consumer
Price Index and the Inflation Rate