Businesses and government departments frequently use the Consumer Price Index to measure and adjust for inflation. The Bureau of Labor Statistics computes the index by collecting data on what consumers pay each month for basic goods in 200 categories, including food, clothing, housing and transportation. Two indexes are produced: the CPI-U, which measures spending of all urban consumers, and the CPI-W, which measures spending of families that earn over half of their income through hourly wages or clerical work.
Measure and Adjust for Inflation
Because the CPI shows the average change in prices from month to month, many businesses use it in escalation agreements to ensure future payments are expressed in inflation-free dollars. After defining the base payment, determine your reference period and how frequently you want the base payment adjusted to account for inflation. The adjustment formula usually directly proportions the percent change in the base payment to the percent change in the CPI over that time.
Compute Future Earnings
Labor organizations and corporations also use the CPI in collective bargaining agreements. Since the CPI-W measures the spending power of wage earners, it works well in contexts where blue collar wages need to be adjusted over time to reflect changes in the cost of living. The CPI may be used for similar purposes when computing future alimony or child support payments.
The federal government uses the CPI-W to adjust income eligibility levels so people can get needed benefits or assistance. Social security and other federal retirement plans also link their cost-of-living adjustments to the CPI.
Determine the Value of a Dollar
Rental contracts and insurance policies also use the CPI to provide inflation protection and maintain the same value and purchasing power over time. The federal government uses the CPI on a broad scale when formulating fiscal policies for the country. The IRS uses the CPI to periodically adjust income tax brackets so that people do not end up in higher tax brackets simply because of inflation.
Limitations and Criticisms
Since the CPI measures an average, it may not accurately reflect the experience of any one person. Additionally, it doesn't reflect the experience of all population groups. The CPI-U covers 87 percent of the U.S. population, including most people living in urban areas. However, it does not include farmers or other rural residents, military families, or people institutionalized in hospitals or prisons. The CPI-W represents an even narrower scope of people, and only includes about 29 percent of the U.S. population.
- Bureau of Labor Statistics: Consumer Price Index: How to Use the Consumer Price Index for Escalation
- Bureau of Labor Statistics: Consumer Price Index: Frequently Asked Questions
- Bureau of Labor Statistics: Consumer Price Index: Addendum to Frequently Asked Questions
- University of Wisconsin Institute for Research on Poverty: FAQs: What Is the Consumer Price Index and How Is It Used?
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