Measuring the price level

Building the basket

1. Each item is given a weight reflecting its share of the household's £ spending, so bread moves the index less than rent.
2. Each later year's prices are then measured against that base of 100.

Calculating inflation

1. In the base year every price index is 100, so the weighted CPI is also 100.
2. In a later year, multiply each item's price index by its weight and add the results.
3. That sum is the year's CPI, still measured against the base of 100.
4. The inflation rate is then the % change in the CPI from one year to the next.

$$Inflation\; rate=\frac{{CPI}_{new}-{CPI}_{old}}{{CPI}_{old}}\times 100$$

Reading an index

1. An index of 105 means prices are 5% above the base-year level.
2. An index rising from 100 to 103 shows 3% inflation over the period.
3. The index measures the change in prices, not the £ cost of the basket.

Measurement difficulties

1. The basket can become outdated as spending patterns change, so it is revised only periodically.
2. Quality improvements and new products are hard to capture, so a higher price may reflect a better good rather than pure inflation.
3. A single national average cannot match every household's own experience of inflation.

How reliable is the CPI?

1. The CPI is a reliable guide for policy and for index-linking wages or pensions, because it is a consistent, weighted measure of a typical household's spending that can be tracked over time.
2. It is less reliable for any single household, because the fixed basket dates quickly as spending shifts, quality gains and new products are hard to capture, and a national average hides very different personal inflation rates.
3. On balance, the CPI is a sound approximation for the average household and a workable basis for policy, though how well it fits a particular person depends on how closely their spending matches the basket.