Chain Weighted CPI vs. Fixed Consumer Price Index

Several financial experts have recommended the replacement of the fixed CPI with the Chain-Weighted CPI. This has been suggested as a way for the government to save money. This article provides information about the basics of the Chain-Weighted CPI and gives several examples that facilitate the better grasp of the concept behind this term.

Fixed Consumer Price Index

CPI stands for Consumer Price Index. It represents the changes of the prices of consumer goods and services on the basis of a consumer basket. Since it is difficult to measure the prices of all goods and services, this basket of consumer goods and services is created. The prices of the latter are estimated over specific periods of time.

Fixed CPI Drawbacks

The drawbacks of the fixed CPI include the following:

1. Quality bias

   The fixed CPI doesn't take into consideration the improvements and declines in the quality of the products. This means that a product that the fact that a product has increased its quality isn't taken into consideration. The vise versa is also true. The fixed consumer price index doesn't consider the decrease in the quality of a product as well.

2. New product bias

   Unfortunately, it takes time for a new product that has a great effect in our lives to be included in the consumer basket. For example, the inclusion of computers which enjoyed high popularity among its users and represented a big portion of their spending was not included in the calculations of the consumer price index until recently. Meanwhile, the prices of computers have gone through major changes with respect to declining levels.

3. Discounting and substitution

   The introduction of new channels for the purchase of goods and services has not been taken under consideration in the computation of the CPI. For example, you may have bought a digital camera from an online shop, but the consumer price index will take the price that is charged at a traditional off-line shop, which may be quite different.

Now let's turn our attention to the Chain-Weighted CPI.

Chain Weighted CPI Basics

Since the fixed CPI has its drawbacks, the Chain-Weighted CPI was created in order to fix these gaps. The Chain-Weighted CPI takes into consideration the changes that are occurring in the spending habits of consumers. It implements weight shifting, which means the shift from one product to another due to the changed needs of the consumer.

In order to further clarify this, consider the following example:

The Basket of Goods of John:

In order to calculate the change in the fixed CPI, we should use the quantities from 2005. The calculations go as follows:

(25 Theatre tickets x $45) + (12 Cinema tickets x $10) x 100 _{= 105.5 or 5.5% inflation rate}

(25 Theatre tickets x $40) + (12 Cinema tickets x $15)

By using the Chain-Weighted method, the change in the CPI will be calculated as follows:

(15 Theatre tickets x $45) + (18 Cinema tickets x $10) x 100 _{= 72.5 or 27.5% deflation}

(25 Theatre tickets x $40) + (12 Cinema tickets x $15)

We hope that this example clearly shows how big a difference can be made by the choice between the two CPI calculation approaches. For the government, pension plans, benefits and budgets for most companies, as well for salaries, every tenth of a percent is of importance. Therefore, it will not be surprising if many organizations move to the Chain Weighted consumer price index approach once it is confirmed by the government.

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