Market Basket

A market basket is a fixed set of goods and services whose prices are tracked to measure changes in the cost of living or in the price level. The market basket is the basis for the construction of price indices, including the consumer price index.

Construction

The market basket is constructed from data on the expenditure of households, which are collected through household budget surveys. The surveys provide information on the goods and services that households buy and on the shares of expenditure allocated to each.

The basket includes the goods and services that are consumed by the reference population, and the weights reflect the share of total expenditure allocated to each item. The basket is updated periodically, to reflect changes in consumption patterns.

The composition of the basket reflects the consumption patterns of the reference population, which may be the whole population or a particular group. The choice of the reference population affects the relevance of the index for different purposes.

Price Index Construction

The price index is calculated by tracking the prices of the items in the basket and combining them into an index. The simplest approach is to compute the cost of the basket at current prices and divide it by the cost at base-period prices, giving a Laspeyres index.

The Laspeyres index uses the quantities of the base period as weights, and it therefore overstates the increase in the cost of living, since it does not account for the substitution of consumers away from goods whose prices have risen. The Paasche index uses current quantities as weights and understates the increase. The Fisher index, which is the geometric mean of the two, is often used as a compromise.

Substitution and Quality

The treatment of substitution is a central issue in the construction of price indices. Consumers respond to changes in relative prices by substituting away from goods that have become relatively expensive, and an index that ignores this substitution overstates the increase in the cost of living.

The treatment of quality is another issue. When the quality of a good improves, the price increase may reflect the improvement rather than a change in the value of money. Hedonic methods are used to adjust for quality and to construct constant-quality price indices.

The introduction of new goods also raises issues, since the basket must be updated to include them. The treatment of new goods affects the measured rate of inflation, and the methods used to incorporate them vary across countries.

Uses

The market basket and the price index constructed from it are used to measure inflation and to index payments, including wages, pensions, and social benefits. The index is used in monetary policy, where the central bank targets the rate of inflation measured by the index.

The choice of the index matters for the assessment of the cost of living and for the design of policy. Different indices, including the consumer price index and the personal consumption expenditure deflator, may give different measures of inflation, and the choice affects the interpretation of the data.

The Consumer Price Index

The consumer price index is the most widely used measure of inflation, constructed from the market basket of goods and services consumed by households. The index is published monthly and is used to index payments and to inform monetary policy.

The construction of the index involves the selection of the basket, the collection of prices, and the combination of the prices into an index. The basket is updated periodically to reflect changes in consumption patterns, and the prices are collected from a sample of outlets.

The index is subject to several sources of bias. The substitution bias arises from the use of fixed weights, which do not account for the substitution of consumers away from goods whose prices have risen. The quality bias arises from the difficulty of adjusting for changes in quality. The new goods bias arises from the delay in incorporating new goods into the basket.

Alternative Measures

Several alternative measures of inflation are used, each with different coverage and different properties. The personal consumption expenditure deflator measures the prices of the goods and services consumed by households, and it is used by some central banks as the target measure.

The producer price index measures the prices received by producers, and it is used as an indicator of the pressures on consumer prices. The GDP deflator measures the prices of all the goods and services produced in the economy.

The measures differ in their coverage, in their treatment of the components of expenditure, and in their methods of construction. The differences matter for the assessment of inflation and for the design of policy.

The Use of the Index

The consumer price index is used to index payments, including wages, pensions, and social benefits. The use of the index protects the recipients from inflation, but it can also create a feedback, in which the indexation of wages raises costs and prices, contributing to inflation.

The index is also used in the measurement of real interest rates and of real wages. The distinction between nominal and real values requires a price index, and the choice of the index affects the measurement.

The index is used in the conduct of monetary policy, where the central bank targets the rate of inflation measured by the index. The choice of the target measure and the treatment of volatile components, including energy and food, affect the design of policy.

Summary

The market basket is the basis for the construction of price indices, and its composition and its treatment of substitution and of quality affect the measurement of inflation. The index is used for a wide range of purposes, and its limitations inform the interpretation of the data.

See also

• Consumer Behaviour
• Inflation
• Hedonic Pricing