Measuring Inflation and the CPI
In one line. Inflation is a sustained rise in the general price level. It is measured by the consumer price index, which tracks a weighted basket of goods against a base year; the inflation rate is the percentage change in the CPI. Headline inflation covers the full basket, core inflation strips out volatile items, and a falling rate is not a falling price level.
Exam relevance: a core A Level Economics topic, on ETG analysis of the last ten years. Taught the way an economics tutor who wrote the answer keys teaches it.
01What inflation is
Inflation is a sustained rise in the general price level, which is not the same as a one off jump in the price of a single good.
Inflation is a sustained increase in the general price level of an economy over a period of time, which lowers the purchasing power of money.
Three words in that definition carry the meaning. Sustained rules out a one off blip. General means prices across the economy on average, not one product. And the price level is the broad measure that an index has to capture. As prices rise, each unit of money buys less, so inflation is also a fall in the value of money.
02The CPI and the basket
The general price level cannot be observed directly, so it is tracked with an index built from a representative basket of what households buy.
The consumer price index (CPI) tracks the price of a fixed, weighted basket of goods and services bought by a typical household, measured relative to a base year set at 100.
Each item in the basket is given a weight reflecting its share of household spending, so a rise in the price of a large item, such as housing, moves the index more than a rise in a small one. The inflation rate is then the percentage change in the CPI from one period to the next. Because the basket and weights are fixed for a time, the CPI isolates price changes from changes in what is bought.
Want this on paper? Grab the free 112 page Summary and Diagrams pack.
03Price level against inflation rate
The single most important distinction in reading inflation data is between the level of prices and the rate at which they are changing.
If the inflation rate falls from 4 per cent to 2 per cent, prices are still rising; they are simply rising more slowly. This is called disinflation, and the price level is higher than before, not lower. The price level only falls when the inflation rate turns negative, which is deflation. In a case study, describing data precisely means saying whether the price level rose or fell and whether the rate rose or fell, because they can move in opposite directions at the same time.
A falling inflation rate is disinflation, and prices are still rising. A falling price level is deflation, and only then is the inflation rate negative. Saying "prices fell" when only the rate fell is a classic data reading error.
04Headline against core inflation
Two versions of the inflation rate are reported, and they answer different questions.
- Headline inflation is the percentage change in the full CPI, including every item in the basket. It is what households actually face at the till.
- Core inflation strips out the most volatile items, food and energy and, in Singapore, private transport and accommodation, to reveal the steadier underlying trend.
Volatile items swing for reasons unrelated to underlying demand pressure, such as a poor harvest or an oil price shock, so they can make headline inflation jump and then reverse. Core inflation filters that noise out, which is why central banks watch it closely when judging whether inflation is genuinely building.
05Not the same as a one off price rise
A single price increase, however large, is not inflation unless it is part of a sustained and general rise in the price level.
If the price of one good jumps because of a temporary shortage and then settles, the general price level has barely moved, and the economy is not experiencing inflation. Inflation requires prices across the economy to keep rising over time. This distinction matters because the policy response differs: a one off relative price change corrects itself, whereas sustained inflation reflects ongoing demand or cost pressure that may need a policy response.
06Limitations of the CPI
The CPI is the standard measure, but it is an approximation, and a strong answer knows where it falls short.
Because the basket and weights are fixed for a time, the CPI can misrepresent the typical household when spending patterns change, and it can overstate the cost of living when consumers switch away from goods that have become dearer. It struggles to capture quality changes, so part of a price rise may reflect a better product rather than pure inflation, and it captures new goods only with a lag. And because it is an average, it need not match the inflation actually felt by a household whose spending differs from the basket, for example one that spends a large share on a category rising faster than the average.
A falling inflation rate does not mean prices are falling. Disinflation is a slower rise; the price level is still higher than before. Only a negative rate, deflation, means the price level itself is falling. Writing "prices fell" when only the rate fell is the single most penalised reading error on inflation data.
When asked to evaluate an inflation figure, do not just quote it. Note whether it is headline or core, whether the rate or the level is being described, and that the basket is an average that may not match a particular group. Those qualifications turn a definition into analysis.
07Test yourself
- An economy's inflation rate falls from 5 per cent to 1 per cent. State precisely what has happened to the price level, and name the term for this.
- Explain why core inflation is watched alongside headline inflation when judging inflationary pressure.
- Give two reasons why the CPI may not reflect the cost of living faced by a particular household.
Key terms on this page
Consumer price indexInflationCore inflationPrice levelDisinflationDeflation
08Questions students ask
The consumer price index, or CPI, tracks the price of a fixed, weighted basket of goods and services that a typical household buys, measured relative to a base year. The percentage change in the CPI from one period to the next is the inflation rate, so the CPI is the measure from which inflation is calculated.
The price level is how high prices are; the inflation rate is how fast they are rising. A falling inflation rate, called disinflation, still means prices are rising, just more slowly, so prices are higher than before. Only a negative inflation rate, deflation, means the price level is actually falling. Confusing the two is one of the most common errors.
Core inflation strips the volatile items, typically food and energy and, in Singapore's case, private transport and accommodation, out of the headline measure. Because those items swing sharply for reasons unrelated to underlying demand, core inflation gives a steadier picture of the inflation trend that policy responds to.