Consumer Price Index Manual : Theory and Practice

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 2004
• eBook ISBN: 9789221136996

NONE

1 AN INTRODUCTION TO CONSUMER PRICE INDEX METHODOLOGY

1.1 A price index is a measure of the proportionate, or percentage, changes in a set of prices over time. A consumer price index (CPI) measures changes in the prices of goods and services that households consume. Such changes affect the real purchasing power of consumers’ incomes and their welfare. As the prices of different goods and services do not all change at the same rate, a price index can only reflect their average movement. A price index is typically assigned a value of unity, or 100, in some reference period and the values of the index for other periods of time are intended to indicate the average proportionate, or percentage, change in prices from this price reference period. Price indices can also be used to measure differences in price levels between different cities, regions or countries at the same point in time.

1.2 Much of this manual and the associated economic literature on price indices is concerned with two basic questions:

• Exactly what set of prices should be covered by the index?
• What is the most appropriate way in which to average their movements?

These two questions are addressed in the early sections of this introduction.

1.3 Consumer price indices (CPIs) are index numbers that measure changes in the prices of goods and services purchased or otherwise acquired by households, which households use directly, or indirectly, to satisfy their own needs and wants. Consumer price indices can be intended to measure either the rate of price inflation as perceived by households, or changes in their cost of living (that is, changes in the amounts that the households need to spend in order to maintain their standard of living). There need be no conflict between these two objectives. In practice, most CPIs are calculated as weighted averages of the percentage price changes for a specified set, or “basket”, of consumer products, the weights reflecting their relative importance in household consumption in some period. Much depends on how appropriate and timely the weights are.

1.4 This chapter provides a general introduction to, and overview of, the methodology for compiling CPIs. It provides a summary of the relevant theory and practice of index number compilation that is intended to facilitate the reading and understanding of the detailed chapters that follow, some of which are inevitably quite technical. It describes all the various steps involved in CPI compilation starting with the basic concept, definition and purpose of a CPI, followed by the sampling procedures and survey methods used to collect and process the price data, and finishing with a summary of the actual calculation of the index and its dissemination.

1.5 An introductory presentation of CPI methodology has to start with the basic concept of a CPI and the underlying index number theory, including the properties and behaviour of the various kinds of index number that are, or might be, used for CPI purposes. In principle, it is necessary to settle what type of index to calculate before going on to consider the best way in which to estimate it in practice, taking account of the resources available.

1.6 The main topics covered in this chapter are as follows:

• –the origins and uses of CPIs;
• –basic index number theory, including the axiomatic and economic approaches to CPIs;
• –elementary price indices and aggregate CPIs;
• –the transactions, activities and households covered by CPIs;
• –the collection and processing of the prices, including adjusting for quality change;
• –the actual calculation of the CPI;
• –potential errors and bias;
• –organization, management and dissemination policy. In contrast, in this manual, the chapters dealing with index theory come later on; thus the presentation in this chapter does not follow the same order as the corresponding chapters of the manual.

1.7 It is not the purpose of this introduction to provide a complete summary of the contents of the manual. The objective is rather to provide a short presentation of the core methodological issues with which readers need to be acquainted before tackling the detailed chapters that follow. Some special topics, such as the treatment of certain individual products whose prices cannot be directly observed, are not considered here as they are not central to CPI methodology.

The origins and uses of consumer price indices

1.8 CPIs must serve a purpose. The precise way in which they are defined and constructed depends very much on what they are meant to be used for, and by whom. As explained in Chapter 15, CPIs have a long history dating back to the eighteenth century. Laspeyres and Paasche indices, which are still widely used today, were first proposed in the 1870s. They are explained below. The concept of the cost of living index was introduced early in the twentieth century.

1.9 Traditionally, one of the main reasons for compiling a CPI was to compensate wage-earners for inflation by adjusting their wage rates in proportion to the percentage change in the CPI, a procedure known as indexation. For this reason, official CPIs tended to become the responsibility of ministries of labour, but most are now compiled by national statistical offices. A CPI that is specifically intended to be used to index wages is known as a compensation index.

1.10 CPIs have three important characteristics. They are published frequently, usually every month but sometimes every quarter. They are available quickly, usually about two weeks after the end of the month or quarter. They are also usually not revised. CPIs tend to be closely monitored and attract a lot of publicity.

1.11 As CPIs provide timely information about the rate of inflation, they have also come to be used for a wide variety of purposes in addition to indexing wages. For example:

• CPIs are widely used to index pensions and social security benefits.
• CPIs are also used to index other payments, such as interest payments or rents, or the prices of bonds.
• CPIs are also commonly used as a proxy for the general rate of inflation, even though they measure only consumer inflation. They are used by some governments or central banks to set inflation targets for purposes of monetary policy.
• The price data collected for CPI purposes can also be used to compile other indices, such as the price indices used to deflate household consumption expenditures in national accounts, or the purchasing power parities used to compare real levels of consumption in different countries.

1.12 These varied uses can create conflicts of interest. For example, using a CPI as an indicator of general inflation may create pressure to extend its coverage to include elements that are not goods and services consumed by households, thereby changing the nature and concept of the CPI. It should also be noted that because of the widespread use of CPIs to index a wide variety of payments - not just wages, but social security benefits, interest payments, private contracts, etc. - extremely large sums of money turn on their movements, enough to have a significant impact on the state of government finances. Thus, small differences in the movements of CPIs resulting from the use of slightly different formulae or methods can have considerable financial implications. CPI methodology is important in practice and not just in theory.

Choice of index number

1.13 The first question is to decide on the kind of index number to use. The extensive references dealing with index theory in the bibliography reflect the fact that there is a very large literature on this subject. Many different kinds of mathematical formulae have been proposed over the past two centuries. While there may be no single formula that would be preferred in all circumstances, most economists and compilers of CPIs seem to be agreed that, in principle, the index formula should belong to a small class of indices called superlative indices. A superlative index may be expected to provide an approximation to a cost of living index. A characteristic feature of a superlative index is that it treats the prices and quantities in both periods being compared symmetrically. Different superlative indices tend to have similar properties, yield similar results and behave in very similar ways. Because of their properties of symmetry, some kind of superlative index is also likely to be seen as desirable, even when the CPI is not meant to be a cost of living index.

1.14 When a monthly or quarterly CPI is first published, however, it is invariably the case that there is not sufficient information on the quantities and expenditures in the current period to make it possible to calculate a symmetric, or superlative, index. While it is necessary to resort to second-best alternatives in practice, being able to make a rational choice between the various possibilities means having a clear idea of the target index that would be preferred in principle. The target index can have a considerable influence on practical matters such as the frequency with which the weights used in the index should be updated.

1.15 A comprehensive, detailed, rigorous and up-to-date discussion of the relevant index number theory is provided in Chapters 15 to 23 of the manual. The following sections provide a summary of this material. Proofs of the various propositions or theorems stated in this chapter are to be found in the later chapters, to which the reader may refer for further explanation.

Price indices based on baskets of goods and services

1.16 The purpose of an index number may be explained as comparing the values of households’ expenditures on consumer goods and services in two time periods. Knowing that expenditures have increased by 5 per cent is not very informative if we do not know how much of this change is attributable to changes in the prices of the goods and services, and how much to changes in the quantities purchased. The purpose of an index number is to decompose proportionate or percentage changes in value aggregates into their overall components of price and quantity change. A CPI is intended to measure the price component of the change in households’ consumption expenditures. One way to do this is to measure the change in the value of an aggregate, holding the quantities constant.

Lowe indices

1.17 One very wide, and popular, class of price indices is obtained by defining the index as the percentage change, between the periods compared, in the total cost of purchasing a given set of quantities, generally described as a “basket”. The meaning of such an index is easy to grasp and to explain to users. This class of index is called a Lowe index in this manual, after the index number pioneer who first proposed it in 1823 (see Chapter 15). Most statistical offices make use of some kind of Lowe index in practice.

1.18 Let there be n products in the basket with prices P_i and quantities q_i, and let the two periods compared be 0 and t. The Lowe index, P_Lo, is defined as follows:

1.19 In principle, any set of quantities could serve as the basket. The basket does not have to be restricted to the quantities purchased in one or other of the two periods compared, or indeed any actual period of time. The quantities could, for example, be arithmetic or geometric averages of the quantities in the two p...

Table of contents

• Cover Page
• Copyright Page
• Content Page
• Foreword
• Preface
• Acknowledgements
• Reader’s guide
• 1 An introduction to consumer price index methodology
• 2 Uses of consumer price indices
• 3 Concepts and scope
• 4 Expenditure weights and their sources
• 5 Sampling
• 6 Price collection
• 7 Adjusting for quality change
• 8 Item substitution, sample space and new products
• 9 Calculating consumer price indices in practice
• 10 Some special cases
• 11 Errors and bias
• 12 Organization and management
• 13 Publication, dissemination and user relations
• 14 The system of price statistics
• 15 Basic index number theory
• 16 The axiomatic and stochastic approaches to index number theory
• 17 The economic approach to index number theory: The single-household case
• 18 The economic approach to index number theory: The many-household case
• 19 Price indices using an artificial data set
• 20 Elementary indices
• 21 Quality change and hedonics
• 22 The treatment of seasonal products
• 23 Durables and user costs
• A glossary of main terms
• Annex 1 Harmonized Indices of Consumer Prices (European Union)
• Annex 2 Classification of Individual Consumption according to Purpose (COICOP)-Extract
• Annex 3 Resolution concerning consumer price indices adopted by the Seventeenth International Conference of Labour Statisticians, 2003
• Annex 4 Spatial comparisons of consumer prices, purchasing power parities and the International Comparison Program
• Bibliography
• Index
• List of tables
• Footnotes