McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 13 Overstatement of the Cost of Living by the CPI

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline THE EVIDENCE THAT CPI IS OVERSTATED CONSEQUENCES OF (NOT) FIXING THE CPI

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The CPI The CPI is an index of indexes. –Each category of good and service generates an index. –These indexes are then used to create a more encompassing index.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Flaws in the CPI: Substitution There is no accounting for substitutions between goods when relative prices change. –If the price of one type of apple increases and the price of another does not, people may substitute one for the other. –This overstates the impact on the cost of living from this price increase.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Flaws in the CPI: Where People Buy People have changed the places they buy goods. –People no longer exclusively shop in traditional grocery stores but buy much of their food at discount warehouse stores. –People buy consumer electronics at large home appliance stores rather than relatively expensive department stores. When people change the venue in which they purchase goods and the Bureau of Labor Statistics (BLS) does not change where they survey, this overstates the increase in the cost of living.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Flaws in the CPI: When People Buy As more people work, specifically as more women work, people change when they buy goods. –People no longer shop mostly on weekdays but use weekends and holidays to shop. When people change when they purchase goods and the BLS does not change, the BLS will miss weekend and holiday sales and this overstates the increase in the cost of living.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Flaws in the CPI: Quality The treatment of improvements in the quality of goods is inadequate. –Though improvements in computers are accounted for, the improvements in the other products has not. –Meat and produce are of higher quality today than years ago. They are fresher and less likely to make you sick.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Flaws in the CPI: Infrequent Updates Changes in the Market Basket are too infrequent. –Common goods not in the current market basket of goods: DVD players Palm Pilots (and their many substitutes) MP3 players

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Net Results The Boskin Commission estimates that the CPI overstates inflation by 1.1 percentage points each year.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Consequences of Not Fixing the CPI Social Security Benefits are increased by more than in necessary to compensate for inflation. The Poverty Line is increased by more than is necessary to compensate for inflation. Tax brackets are increased by more than is necessary to prevent bracket creep thereby cutting taxes.

McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Politics of the CPI Adjustment To Republicans fixing the CPI would have the same effect as a tax increase. To Democrats fixing the CPI would have the same impact as a cut in benefits to the poor and elderly. Politics trumps economics.