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Lesson M02.L01: The Consumer Price Index: Construction and Uses

Module: Measuring the Price Level and Inflation; Savings and Wealth Level: intro Duration: 30 minutes Learning Objective: Explain how the ABS constructs the CPI; describe its uses for indexing wages, pensions, and RBA policy; identify its main limitations. Provenance: OpenStax Macro 3e | Khan Academy Macro

Explanation

The Consumer Price Index (CPI) measures the change in the price of a fixed basket of goods and services that a typical household buys. In Australia, the ABS publishes the CPI quarterly (cat. 6401.0).

How the ABS constructs the CPI:

  1. Define the basket: ABS surveys around 10,000 households via the Household Expenditure Survey (HES) to identify what Australians actually buy. The basket includes food, housing, transport, healthcare, education, and more — 87 expenditure classes in total.
  2. Assign weights: Each category gets a weight proportional to how much of the average budget it consumes. In 2023, housing (rents, utilities, new dwellings) had the largest weight (~22%).
  3. Collect prices: ABS price collectors survey ~100,000 prices across eight capital cities each quarter.
  4. Calculate the index: Compare this quarter's basket cost to the base-period cost. The current base period is 2011–12 = 100.

Key uses: - Wage indexation: Many enterprise agreements link pay rises to CPI. - Pension and welfare adjustments: Age Pension is benchmarked against both wages and CPI. - RBA inflation target: The RBA targets CPI inflation of 2–3% on average over time. When inflation exceeds this band, the RBA typically raises the cash rate. - Contract deflation: Long-term contracts (e.g., infrastructure projects) use CPI to maintain real value.

Main limitations: - Substitution bias: The basket is fixed, so CPI ignores consumers switching to cheaper alternatives when prices rise. - Quality change: If a laptop gets faster but the price stays the same, CPI misses the improvement. - New goods: New products (e.g., streaming services) enter the basket with a lag. - Spatial variation: A single national CPI masks big cost-of-living differences between Sydney and regional Queensland.

Worked Example

Suppose the ABS basket in the base year costs \(1,000**. By 2023 the same basket costs **\)1,157.

CPI₂₀₂₃ = (1,157 / 1,000) × 100 = 115.7

This means prices are 15.7% higher than in the base year.

The annual inflation rate from 2022 to 2023: - CPI₂₀₂₂ = 108.0, CPI₂₀₂₃ = 115.7

Inflation = (115.7 − 108.0) / 108.0 × 100 = 7.1%

This simplified two-item example yields 7.1%, illustrating the mechanics of index construction. The actual ABS CPI — drawn from over 90,000 price observations across hundreds of goods and services — reported headline inflation of 7.8% for the year to December 2022, the peak of Australia's post-COVID inflation surge.

Common Misconception

Misconception: The CPI measures the price of everything in the economy.

Correction: The CPI measures only the prices in a specific consumer basket — goods and services that households typically purchase. It does not cover business investment goods, exports, or government services not paid for directly by consumers. The GDP deflator is a broader measure covering all domestically produced goods and services.

Practice Prompts

  1. The ABS basket costs $1,200 in the base year and $1,350 in the current year. What is the CPI? → Answer: (1,350 / 1,200) × 100 = 112.5.

  2. Name two ways Australia uses the CPI outside of measuring inflation. → Answer: Any two of: adjusting the Age Pension, indexing wages in enterprise agreements, deflating long-term contracts, guiding RBA interest rate decisions.

  3. Why does the CPI tend to overstate true inflation? → Answer: The CPI uses a fixed basket and ignores substitution — when prices rise, consumers switch to cheaper alternatives, but the CPI still prices the original basket. This substitution bias makes measured inflation slightly higher than experienced inflation.

Further Resources