Inflation & Index Numbers Problems & Issues Dr. D. Foster – ECO 285

Inflation & Index Numbers Problems & Issues What are we measuring? The biases: substitution/quality/new/distribution … Inflation as the ultimate individual statistic. Effects of inflation Other measures: PPI/CPI-E/GDP Deflator/ The conspiracy theory.

What are we measuring? Is it the price level? Is it the value of money? Is it a consumption bundle? Is it the cost of living?

* 2 = * 3 = * 4 = What are we measuring? 2018 1980 Consider computer programmers in 1980 vs. 2018. 2018 1980 * 2 = $37.50/hr * 3 = $25/hour * 4 = $18.75/hr $25/hour $75/hour Is there inflation? If programmers today are 2, 3, 4 times as productive today … But all we know is what they were/are being paid!!!

It gets worse … Did prices rise in 2018? We are using a subjective measure – price – to discern objective information on inflation!! $.50 2017 $1.00 2018 $.25 2018 Did prices rise in 2018? We can’t tell, because prices measure value!!! demand because apples prevent cancer. Did prices fall in 2018? We can’t tell, because prices measure value!!! demand because apples cause cancer.

Last word? - Callahan I have no objection to measuring anything that can meaningfully measured. However, the problem with price indices is not that they are inaccurate, but that the idea of a price index can't even be defined coherently. Moreover, such indices are used to justify any amount of economic tinkering on the part of the government, whereby it displays its ability to "control" numbers that are its own arbitrary creation. The most beneficial change that the government could initiate in this field would be to fire all its econometricians, lowering the "price level" of our taxes.

Substitution Bias “Lower level” “Upper level” Consumers substitute across brands. Increase price of Whopper but not Big Mac and people buy more Big Macs. This is “mimicked” by CPI-U since 2002 due to its use of geometric means . “Upper level” Substitution across categories. Price of chicken rises and people buy more pork. This is incorporated into the C-CPI-U calculation.

Quality Bias If quantifiable, easy to include. If not quantifiable … Candy bar falls from 8 oz. to 6 oz. while price stays at $.50. Will be recorded as $.67 and add to inflation. If not quantifiable … Just guessing. Gas additive example. Based on hedonic pricing techniques. We aren’t recording real $ values.

Outlet/Distribution Bias New Product Bias Incompatible with fixed basket of goods. By the time it is included, its price has fallen!! CPI-U and CPI-W update baskets every 2 years. C-CPI-U updates basket every month. Outlet/Distribution Bias Not every price is recorded. Prices differ depending on location & store. If Sam’s Club is missed, low end not represented. Today, web purchases would further complicate this aspect.

Other Biases Small Sample Bias Rental Equivalence Bias When only a few observations are recorded for an item & the geometric mean is derived. Calculated value is overstated . Rental Equivalence Bias The value of owner occupied homes – what they would rent for. You can’t presume this would be the market rent.

Individuals – the ultimate bias You don’t buy what is in the basket. You don’t buy the same proportion as the basket. Establishing one single number for “inflation” is meaningless. Inflation is the ultimate individual statistic. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred… [T]hey provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell.

The Effects of Inflation If unexpected: Recipients of fixed incomes are losers . . . Payers of fixed amounts are winners . . . Real interest returns fall (r = i - inflation). If expected . . . it shouldn’t matter, but: Repricing costs (less now with scanners). Inconvenience costs if money holdings fall. Real economic costs if workers want compensation for the uncertainty. If high, to pull it down requires a recession and an increase in unemployment.

Producer Price Index (PPI) Basket of producer goods. Considered a leading indicator.

“Elderly” CPI (PPI-E) Basket of goods for those >62 years old. “Experimental ” and unpublished.

GDP Deflator Nominal GDP = P * Q = (price level)*(real GDP) Rearrange: P (GDP Deflator) = (Nom. GDP)/(Real GDP)

“Core” CPI – less food/energy Because food & energy prices are quite volatile ...

Something fishy about the CPI? Schiff: official numbers seem wrong. Constructed new basket … Compared SPI to CPI: Close in 1970s (117% vs. 112%) but not 2000s (44% vs. 27%) Newspaper index & health insurance. Boring: gov’t has an incentive to lowball est. BLS won’t release data. BLS vs. USDA on beef prices. Methodologies changed 20 times over 30 years. Why not look at money growth directly?

Inflation & Index Numbers Problems & Issues Dr. D. Foster – ECO 285