Consumer price index compares the price changes with changes in income, wage rates, retail sales etc. Consumer price index is also known as cost of living index and can be used to know whether income keeps pace with the cost of living. The importance of consumer price index can be illustrated with the help of purchasing power of rupee and deflation of per capita income.
Purchasing power of Rupee
The purchasing power of a rupee is the reciprocal of consumer price index, multiplied by 100. It shows the value of a rupee received in current time period relative to base period prices. For example consumer price index of 1988 to the base year 1984 is 151.30 then P.P = 0.66. It means that rupee received in 1988 is worth 0.66 compared to the rupee received in 1984. In other words, the 1988 rupee is valued at 66% of a 1984 rupee, a decline in purchasing power of 34%.
Problem: For the following consumer price index, calculate the purchasing power of rupee for each of the years.
Deflation of Per capita Income
Consumer price index can be used to remove the effect of changing prices on per capita income by deflating the income expressed in current money by consumer price index. This relationship may be expressed as; Real Rupee = (Current Rupee) × (Purchasing Power). In this case real rupee is also known as constant rupee. For example the income of individual in 2010 is 30000 and the purchasing power of rupee is 0.66 (from 2000-2010) then his real income in 2010 as compared to 2000 is 30000*0.66 = 19800. It shows that income of Rs 30000 in 2010 can purchase only Rs 19800 worth of goods and services at 2000 prices.
Problem: Deflate the per capita income by the consumer price index given in the following table.
Per capita income can be deflated by dividing it by the consumer price index and multiplying the resultant by 100.
That the changes in real per capita income are small as compared to those in current per capita income.