The Surprising relationship between Inflation and CPI in Kenya
Consumer Price Index (CPI) and inflation are two terms that are often mentioned together in economic discussions. They are both crucial indicators of a nation's economic health and have a profound impact on various aspects of daily life. In this article, we will delve into the relationship between CPI and inflation
Understanding CPI
Consumer Price Index (CPI) is a measure that tracks the changes in the average prices paid by consumers for a basket of goods and services over time. It is essentially a yardstick used to gauge the cost of living and, consequently, the level of inflation within an economy. CPI is calculated by surveying a representative sample of households and assessing their expenditures on various items such as food, housing, clothing, transportation, and entertainment. This information is then used to construct a weighted average that reflects the overall change in prices.
Inflation: The Silent Eroder of Purchasing Power
Inflation, on the other hand, is a broader economic concept that refers to the general increase in the prices of goods and services in an economy over time. Inflation erodes the purchasing power of a currency, which means that the same amount of money can buy fewer goods and services as time goes on. This phenomenon can have a cascading effect on individuals, businesses, and the economy as a whole.
The Relationship
So, how are CPI and inflation related?
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CPI as an Inflation Indicator: CPI serves as a key indicator for inflation. When CPI increases, it typically signals that the average price level of goods and services has gone up, indicating inflationary pressure. Conversely, a decrease in CPI suggests deflationary pressure, where prices are falling.
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Inflation Measurement: CPI is commonly used as the benchmark for measuring inflation in an economy. Central banks and governments regularly monitor CPI to assess the pace of inflation and make informed policy decisions, such as adjusting interest rates or implementing fiscal measures.
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Inflation's Impact on CPI: Inflation directly affects the components of CPI. When prices rise across the board, it becomes more expensive for consumers to purchase the same goods and services, which is reflected in CPI calculations.
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CPI's Role in Cost-of-Living Adjustments: CPI is also instrumental in determining cost-of-living adjustments (COLAs) for various government benefits, such as Social Security payments and pensions. This ensures that these payments keep pace with rising prices, maintaining the real income of recipients.
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Economic Health: The relationship between CPI and inflation is an essential gauge of economic health. Moderate inflation is generally considered a sign of a healthy economy, as it reflects increasing demand and economic growth. However, excessive inflation can lead to economic instability, as it erodes confidence in the currency and can disrupt business operations.
Therefore, we expect that they are positively correlated. But we must test that. Remember, with data, trust but verify..
What statistical measures can we use to effectively measure this relationship? Can one be use as a predictor of the other?
Using Pearson's Correlation Coefficient
The correlation coefficient for data between January 2015- March 2023 is 0.1738.
Interpretation
The result is definitely a number between -1 and 1. A value close to 1 indicates a strong positive correlation, while a value close to -1 indicates a strong negative correlation. A value close to 0 suggests little to no correlation.
Conclusion
There is little correlation between CPI and Inflation in Kenya.
To visually represent this relationship, we use a scatterplot as shown below:
Interpretation
Trend Direction:
- If the points on the scatter plot generally move from the lower left to the upper right, it suggests a positive correlation. In this case, as inflation increases, CPI tends to increase as well.
- If the points move from the upper left to the lower right, it indicates a negative correlation. In this scenario, as inflation increases, CPI tends to decrease.
- If the points seem randomly scattered with no clear trend, it suggests little to no correlation between the two variables.
Clusters or Patterns:
- If most data points form a distinct curve or cluster around a line, it might indicate a non-linear relationship or a specific pattern between the variables.
Conclusion
The points are seen to generally move from lower left to upper right, indicating a positive correlation, however little.
There is a curve beginning to show, indicating a form of non-linear relationship
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