Final answer:
The Consumer Price Index (CPI) is a measure of inflation based on a fixed basket of goods representing the average household purchases. It is subject to biases like substitution and quality/new goods bias. Other inflation measures like the Core Inflation Index and GDP deflator address different aspects of price changes.
Step-by-step explanation:
Understanding the Consumer Price Index (CPI)
The Consumer Price Index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households.
The CPI calculation uses a fixed basket of goods set in the base year and compares this to the prices of the same goods in subsequent years. However, it's important to notice that CPI may not perfectly represent changes in the cost of living due to limitations such as substitution bias and quality/new goods bias.
Substitution bias arises because a fixed basket does not account for consumers buying more of what becomes cheaper and less of what becomes expensive. Quality/new goods bias happens as the fixed basket cannot account for improvements or the introduction of new goods over time.
While CPI is based on this fixed basket, the basket is reviewed and can be altered to some degree to account for changes in consumer spending patterns, which partially addresses these biases. The Core Inflation Index is a version of the CPI that excludes volatile economic commodities to provide a clearer picture of underlying inflation trends.
It's essential to differentiate CPI from other price indices, like the GDP deflator, which is based on all GDP components, and the Producer Price Index, which reflects prices for producers. Another index, the Employment Cost Index, measures wage inflation, while the International Price Index tracks prices of exports and imports.
Although CPI is a crucial tool for measuring inflation, it does not account for changes in consumer spending patterns and utility. However, it remains the most commonly cited measure of inflation, calculated by the U.S. Bureau of Labor Statistics based on a basket representing the average family of four's purchases.