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APPENDIX

A

Background and Current Uses of the Consumer Price Index

The CPI is a measure of the average change over time in the prices paid by urban consumers in the United States for a fixed basket of goods in a fixed geographic area. The CPI was developed during World War I so that the federal government could establish cost-of-living adjustments for workers in shipbuilding centers. Rapid increases in prices had made such an index necessary for calculating these adjustments.

Today, the CPI is the principal source of information concerning trends in consumer prices and inflation in the United States. It is widely used as an economic indicator and a means of adjusting other economic series (e.g., retail sales, hourly earnings) and dollar values used in government programs. The CPI is used to adjust payments to Social Security recipients and to Federal and military retirees, and for a number of entitlement programs such as food stamps and school lunches. Also, individual income tax brackets and personal exemptions are adjusted for inflation using the CPI. The index's impact on the finances of the federal government is significant. In fiscal year 1996, for example, the Office of Management and Budget estimated that each one-percent increase in the CPI produced a $5.7 billion increase in outlays and a $2.5 billion decline in revenues. In addition, as the most widely used index for measuring inflation, the CPI aids in the formulation of fiscal and monetary policies and in economic decision-making.

The CPI measures the rates of changes in prices, not their absolute levels. Most of the specific CPI indexes have a 1982-84 reference base.



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Page 119 APPENDIX A Background and Current Uses of the Consumer Price Index The CPI is a measure of the average change over time in the prices paid by urban consumers in the United States for a fixed basket of goods in a fixed geographic area. The CPI was developed during World War I so that the federal government could establish cost-of-living adjustments for workers in shipbuilding centers. Rapid increases in prices had made such an index necessary for calculating these adjustments. Today, the CPI is the principal source of information concerning trends in consumer prices and inflation in the United States. It is widely used as an economic indicator and a means of adjusting other economic series (e.g., retail sales, hourly earnings) and dollar values used in government programs. The CPI is used to adjust payments to Social Security recipients and to Federal and military retirees, and for a number of entitlement programs such as food stamps and school lunches. Also, individual income tax brackets and personal exemptions are adjusted for inflation using the CPI. The index's impact on the finances of the federal government is significant. In fiscal year 1996, for example, the Office of Management and Budget estimated that each one-percent increase in the CPI produced a $5.7 billion increase in outlays and a $2.5 billion decline in revenues. In addition, as the most widely used index for measuring inflation, the CPI aids in the formulation of fiscal and monetary policies and in economic decision-making. The CPI measures the rates of changes in prices, not their absolute levels. Most of the specific CPI indexes have a 1982-84 reference base.

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Page 120 That is, the average price level for the 36-month period covering these years is established as having an index level of 100. A 10-percent increase in price since this reference period would then correspond to an index level of 110. The Bureau of Labor Statistics currently produces two national indices every month: the CPI for All Urban Consumers (CPI-U) and the more narrowly based CPI for Urban Wage Earners and Clerical Workers (CPI-W), which is developed using only data from households represented in certain occupations. In addition to monthly release of the national CPI estimates, the BLS publishes monthly indexes for the four principal regions of the nation (Northeast, Midwest, South, and West), as well as for collective urban areas classified by population size. The BLS also publishes indexes for 26 local areas on monthly, bimonthly, or semiannual schedules. An individual area index measures how much prices have changed over a specific time interval in that particular area. However, because of the nature of the index and the specifics of the sampling design, indexes cannot be used for relative comparisons of the level of prices or the cost of living in different geographic areas. In fact, the compositions of the regional market baskets generally vary substantially across areas because of differences in purchasing patterns. COLLECTION OF DATA ON CONSUMER EXPENDITURES The BLS develops the CPI market basket on the basis of detailed information provided by families and individuals about their actual purchases. Information on purchases is gathered from households in the Consumer Expenditure (CE) Survey, which consists of two components: an interview survey and a diary survey. 1 Each component has its own questionnaire and sample. In the quarterly interview portion of the CE survey, an interviewer visits every consumer in the sample every 3 months over a 12-month period. The CE interview survey is designed to collect data on the types of expenditures that respondents can be expected to recall for a period of 3 months or longer. These expenditures include major purchases, such as 1 Much of the material in this section is excerpted from Appendix B of Consumer Expenditure Survey, 1996-97, Report 935, Bureau of Labor Statistics, September 1999.

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Page 121 property, automobiles, and major appliances, and expenses that occur on a regular basis, such as rent, insurance premiums, and utilities. Expenditures incurred on trips are also reported in this survey. The CE interview survey thus collects detailed data on 60 to 70 percent of total household expenditures. Global estimates—i.e., expense patterns for a 3-month period—are obtained for food and other selected items, accounting for an additional 20 percent to 25 percent of total household expenditures. In the diary component of the CE survey, consumers are asked to maintain a complete record of expenses for two consecutive one-week periods. The CE diary survey was designed to obtain detailed data on frequently purchased small items, including food and beverages (both at home and in eating places), tobacco, housekeeping supplies, nonprescription drugs, and personal care products and services. Respondents are less likely to recall such items over long periods. Integrating data from the interview and diary surveys thus provides a complete accounting of expenditures and income. Both the interview and diary surveys collect data on household characteristics and income. Data on household characteristics are used to determine the eligibility of the family for inclusion in the population covered by the Consumer Price Index, to classify families for purposes of analysis, and to adjust for nonresponse by families who do not complete the survey. Household demographic characteristics are also used to integrate data from the interview and diary components. Samples for both the interview and diary components of the Consumer Expenditure Survey are national probability samples of households designed to be representative of the total U.S. civilian population. Sampling occurs in two stages. The first stage of sampling involves the selection of primary sampling units (PSUs) that consist of counties, groups of counties, and portions of counties. The PSUs are classified into four categories: (1) large metropolitan statistical areas (MSAs); (2) medium-sized MSAs; (3) nonmetropolitan areas that are included in the CPI; and (4) nonmetropolitan areas where only the urban population is included in the CPI. Lists of housing units in each PSU are constructed using decennial census data and supplemental information on new housing construction. The second stage of sampling involves the selection of housing units from each PSU for participation in the CE survey. The interview component is a panel rotation survey. Each panel, a set of selected addresses, is interviewed for five consecutive quarters and then dropped from the survey. As one panel leaves the survey, a new panel is

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Page 122 introduced. Thus, approximately 20 percent of the addresses are new to the survey each month. For the 1996 and 1997 CE interview surveys, approximately 9,000 addresses were selected in each quarter. Allowing for nonresponses, the number of suitable interviews per quarter was targeted at approximately 5,400. Thus, more than 5,000 families participate in the interview survey in any given calendar year. The diary component involves drawing a new sample each year, independent both of previous years and of the sample for the interview component. Approximately 7,000 addresses were contacted for the 1996 and 1997 CE diary surveys. Allowing for nonresponses, the number of households providing usable diaries was targeted at approximately 5,400 per year. CONSTRUCTION OF THE CPI MARKET-BASKET SYSTEM The BLS prices the CPI market basket and produces the monthly CPI index using a complex, multistage sampling process. The first stage involves the selection of urban areas that will constitute the CPI geographic sample. Because the CPI market basket is constructed using data from the CE survey, the geographic areas selected for the CPI-U are also used in the CE survey. Once selected, the CPI geographic sample is fixed for 10 years until new census data become available. Using the information supplied by families in the CE surveys, the BLS constructs the CPI market basket by partitioning the set of all consumer goods and services into a hierarchy of increasingly detailed categories, referred to as the CPI item structure. 2 The levels of the CPI classification are: All items Major groups Intermediate aggregates Expenditure classes Item strata (or categories) Entry level items For example, in developing the current market basket the BLS has classified expenditures reported in the 1993-95 CE survey into more than 2 Much of the material in this section and the next section is excerpted from CPI materials available at the Bureau of Labor Statistics web site, http://www.bls.gov.

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Page 123 200 item strata arranged into eight major groups: food and beverages; housing; apparel; transportation; medical care; recreation; education and communication; and other goods and services. For each geographic area (primary sampling unit) included in the CPI geographic sample, the BLS assigns each item category an expenditure weight, or importance, based on its share of total family expenditures. Aggregating weights from the geographic areas in the CPI sample derives item category weights at the national level. Thus, one can ultimately view the CPI market basket as a set of item strata and associated expenditure weights. MONTHLY DATA COLLECTION AND PRICING Following the sampling process, BLS analysts select the outlets (places where area residents make purchases), goods and services (specific items purchased), and residents' housing units to be used in computing the monthly CPI. Selection of the CPI outlet and item samples is based on information from the Telephone Point-of-Purchase Survey (TPOPS), a household survey that provides BLS with a sampling frame of outlets and retail establishments visited by urban consumers. The TPOPS obtains data from about 17,000 families annually on the types of goods and services consumers purchase, the amount of these expenditures, and the places the expenditures are made. Since the 1998 CPI revision, TPOPS data have been collected using computer-assisted telephone interviews (CATI), which allows a portion of all commodities and services to be updated, or rotated, in each sampling unit every year. Within item categories, BLS statisticians select hundreds of entry-level items and match them with the sampled retail outlets for price collection. The number of price quotations and observations to be obtained is determined statistically with the objective of producing the most accurate national all-items index as possible, subject to available funds. The BLS field staff who collect CPI prices use the entry-level items as the starting point for the selection of the unique products or services—within the outlet—whose prices will be monitored. This selection is made using a random probability sampling method that reflects an item's relative share of sales at that particular store. Each month, BLS data collectors, called economic assistants, visit or call thousands of retail stores, service establishments, rental units, and doctors' offices throughout the United States to obtain price information on the thousands of items used to track and measure price change in the CPI.

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Page 124 These economic assistants record the prices of about 80,000 items each month. These 80,000 prices thus represent a scientifically selected sample of the prices paid by consumers for goods and services purchased. UPDATING AND IMPROVING THE CPI MARKET BASKET Because of the many important uses of the monthly CPI, there is great interest in insuring that the CPI market basket accurately reflects changes in consumption over time. Each decade, data from the U.S. census of population and housing are used to update the CPI process in three key respects: (1) redesigning the national geographic sample to reflect shifts in population; (2) revising the CPI item structure to represent current consumption patterns; and (3) modifying the expenditure weights to reflect changes in the item structure as well as reallocation of the family budget. In response to growing demands for a more current CPI market basket, the BLS has redesigned some of the survey processes to enable more frequent revision than once every five or ten years. In particular, the new TPOPS sample design permits a shift to sample rotation by category rather than by geographic area, thereby facilitating accelerated sample rotation in product areas where the markets are most dynamic. The sample rotation involves (1) reselecting the retail stores and business establishments to be visited by BLS field representatives and (2) reselecting the unique products and services to be priced for the market basket. For example, to represent the market basket item category “records and tapes,” a cassette tape sold in Outlet A could be replaced by a compact disc sold in Outlet B. In addition, the sample size of the ongoing CE survey has been increased substantially, which will enable the production of updated expenditure weights every two years starting in January 2002.