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If you're an investor or interested in investing, you're bound to hear about the consumer price index -- and for good reason. It's an important measurement that can help reveal the health of an economy, telling whether inflation is rising and how well economic policy is working. 

What Is the Consumer Price Index?

The Consumer Price Index (CPI) measures the average price change of a set of consumer goods and services. CPIs can be calculated for single items or a predetermined group of items. All of these items are defined as "household goods and services."

Some of the household goods and services that CPI might measure include:

  • Food
  • Transportation
  • Health and medical care
  • Clothing
  • Energy
  • Education
  • Recreation

Typically, the CPI is used to measure inflation and determine the cost of living at a given time. It provides important insight for economists, governments and companies.

How is the Consumer Price Index Used?

The consumer price index is mainly used to measure inflation over a given period of time. It can also be leveraged to determine the cost of living.

CPI is mainly used to determine the efficacy of economic policies. Inflation indicates the health (or lack thereof) of an economy, so tracking it and responding to it appropriately is important for policymakers. When inflation sharply increases or decreases, the CPI provides economists and policymakers insight into how a government's economic policy affects the market.

This gives the ability to better understand whether current policies are working properly and how a government might be able to create better policies in the future. 

The inflation rates and cost of living that CPI identifies can have a huge impact on the financial lives of consumers. In fact, when inflation is identified, the Federal Reserve will often take actions to stop an economy from overheating. This can ultimately result in loans becoming more expensive for borrowers.

CPI can also be used to shape government assistance policies. It will often help determine who is eligible for programs such as social security and other help. It also can result in wage adjustments to account for cost-of-living.

Critical Role of the Consumer Price Index 

The consumer price index is extremely important for measuring the health of our economy.

Inflation can endanger an economy by making the cost of living impossible to maintain, particularly if salaries do not keep pace with rising costs. This ultimately decreases the living standards for consumers, which can lower quality of life. This is especially true when normal inflation leads to hyperinflation, which can financially devastate a nation's economy. Measuring inflation and cost of living using CPI helps governments respond and deescalate inflation, before it can get out of control. Without a feedback loop like CPI, it can become much harder to make educated decisions about economic policy.

Overall, CPI is one of the main methods used to help create and maintain a robust, healthy economy.

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What Goods and Services are Included in the CPI?

Generally speaking, the consumer price index using cost measurements from household goods and services. However, there are two different measures of the CPI. Each serves its own specific purpose and is measured in its own way to include certain goods and services. They are: 

Headline Consumer Price Index

The headline consumer price index uses numbers from the Bureau of Labor Statistics (BLS). The BLS includes every item they measure, which totals to about 80,000 consumer goods and services.

Typically, the prices for these items are pulled from a wide variety of goods and services that are generally purchased by households in urban areas. The items they measure are grouped into the following categories:

  • Housing
  • Clothing
  • Transportation
  • Education
  • Recreation
  • Health care (including medications)
  • Groceries
  • Other goods and services

Anything that falls outside of day-to-day consumption is not included in this measurement, such as securities, real estate, and more.

The people surveyed by the BLS can be employed, self-employed, retired and poor. These numbers represent over three-quarters of the U.S. population, making it a decent representation of the nation.

Core Consumer Price Index

The core consumer price index is slightly different than the headline consumer price index. While it also measures the price of household goods and services, it excludes the prices of food and energy. These items are excluded from the measurement, because prices in these categories tend to fluctuate often and could skew the resulting CPI.

The Federal Reserve leverages the core consumer price index to determine whether it should raise its federal fund rate. This makes the core consumer price index important.

How Is the Consumer Price Index Calculated?

The headline consumer price index calculation formula is posted by the Bureau of Labor Statistics. This allows economists -- and even the average consumer -- the opportunity to calculate the CPI at any time, whether it's for this year or 1945.

Here is the formula published by the BLS:

CPI= Cost of Market Basket in Base Year / Cost of Market Basket in Given Year ×100

To see how inflation has changed the buying power of the dollar from years earlier, see here

Key Takeaways

Here are the key takeaways that you need to know about the CPI:

  • CPI measures the average price change of certain consumer goods and services.
  • CPI can reveal inflation and cost of living over a given period of time.
  • CPI influences government economic policy and helps maintain the health of our economy.
  • Data from the Bureau of Labor Statistics is used to calculate the different different types of CPI: headline CPI and core CPI.
  • Headline CPI measures eight major categories of goods and services. Core CPI does the same, but excluding food and energy costs.