THE CPI AND THE COST OF LIVING Cost of living index A measure of changes in the amount of money that people would need to spend to achieve a given standard of living. The CPI does not measure the cost of living because It does not measure all the components of the cost of living Some components are not measured exactly So the CPI is possibly a biased measure.

THE CPI AND THE COST OF LIVING  Sources of Bias (Discrepancies) in the CPI The potential sources of bias in the CPI are Goods Evolve/New Good Bias Quality Differences Consumer substitutes Outlet substitution bias

THE CPI AND THE COST OF LIVING New Goods Bias What if the market basket base year was from 1912? New goods do a better job than the old goods that they replace, but cost more. The arrival of new goods puts an upward bias into the CPI and its measure of the inflation rate. Quality Change Bias Better cars and televisions cost more than the versions they replace. A price rise that is a payment for improved quality is not inflation but might get measured as inflation.

THE CPI AND THE COST OF LIVING Commodity Substitution Bias If the price of beef rises faster than the price of chicken, people buy more chicken and less beef. The CPI basket doesn’t change to allow for the effects of substitution between goods. Outlet Substitution Bias If prices rise more rapidly, people use discount stores more frequently. The CPI basket doesn’t change to allow for the effects of outlet substitution.

THE CPI AND THE COST OF LIVING  The Magnitude of the Bias The Boskin Commission estimated the bias to be 1.1 percentage points per year. If the measured inflation rate is 3.1 percent a year, most likely the actual inflation rate is 2.0 percent a year. To reduce the bias, the BLS has decided to increase the frequency of its Consumer Expenditure Survey and revise the CPI basket every two years. When the BLS revises the CPI basket, the reference base period does not change.

Inflation  Real World Price Indexes Producer Price Index (PPI) A statistical measure of a weighted average or prices of commodities that firms purchase from other firms. Generally for non-retail markets Used as a leading indicator of the CPI PPI’s for: Food materials Intermediate goods Finished goods

Inflation  Real World Price Indexes GDP Deflator A price index measuring the changes in prices of all new goods and services produced in the economy Broadest measure Not based on a fixed market basket, but a survey of a wide variety of goods.

The GDP Deflator  The GDP Deflator: A Better Measure? In principle, the GDP deflator is not subject to the biases of the CPI because it uses the price change and the public response to those price changes in the basket of goods and services produced in the current year and the preceding year. In practice, the GDP deflator suffers from some of the CPI’s problems because the Commerce Department does not directly measure the physical quantities of all the goods and services that are produced.

THE CPI AND THE COST OF LIVING Figure shows the two measures of inflation in part (a) and the corresponding two measures of the price level in part (b).

THE CPI AND THE COST OF LIVING The two measures of the inflation rate fluctuate together, but the CPI measure rises more rapidly than the GDP deflator measure. But the price levels get farther apart. Both measures probably overstate the inflation rate.

Inflationary Periods in U.S. History