2.2Measuring the Cost of Living: The Consumer Price Index

A dollar today doesn’t buy as much as it did twenty years ago. The cost of almost everything has gone up. This increase in the overall level of prices is called inflation, and the percentage change in the price level from one period to the next is called the inflation rate. Inflation is a primary concern of economists and policymakers. In later chapters we examine in detail the causes and effects of inflation. Here we discuss how economists measure changes in the cost of living.

The Price of a Basket of Goods

The most commonly used measure of the level of prices is the consumer price index (CPI). The Bureau of Labor Statistics, which is part of the U.S. Department of Labor, has the job of computing the CPI. It begins by collecting the prices of thousands of goods and services. Just as GDP turns the quantities of many goods and services into a single number measuring the value of production, the CPI turns the prices of many goods and services into a single index measuring the overall level of prices.

How should economists aggregate the many prices in the economy into a single index that reliably measures the price level? They could simply compute an average of all prices. But this approach would treat all goods and services equally. Because people buy more chicken than caviar, the price of chicken should have a greater weight in the CPI than the price of caviar. The Bureau of Labor Statistics weights different items by computing the price of a basket of goods and services purchased by a typical consumer. The CPI is the price of this basket of goods and services relative to the price of the same basket in some base year.

For example, suppose that the typical consumer buys five apples and two oranges every month. Then the basket of goods consists of five apples and two oranges, and the CPI is

In this CPI, 2014 is the base year. The index tells us how much it costs now to buy five apples and two oranges relative to how much it cost to buy the same basket of fruit in 2014.

The consumer price index is the most closely watched index of prices, but it is not the only such index. Another is the producer price index, which measures the price of a typical basket of goods bought by firms rather than consumers. In addition to these overall price indexes, the Bureau of Labor Statistics computes price indexes for specific types of goods, such as food, housing, and energy. Another statistic, sometimes called core inflation, measures the increase in price of a consumer basket that excludes food and energy products. Because food and energy prices exhibit substantial short-run volatility, core inflation is sometimes viewed as a better gauge of ongoing inflation trends.

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How the CPI Compares to the GDP and PCE Deflators

Earlier in this chapter we saw another measure of prices—the implicit price deflator for GDP, which is the ratio of nominal GDP to real GDP. The GDP deflator and the CPI give somewhat different information about what’s happening to the overall level of prices in the economy. There are three key differences between the two measures.

The first difference is that the GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought only by firms or the government will show up in the GDP deflator but not in the CPI.

The second difference is that the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of Toyotas made in Japan and sold in this country affects the CPI, because the Toyotas are bought by consumers, but it does not affect the GDP deflator.

The third and most subtle difference results from the way the two measures aggregate the many prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes. The following example shows how these approaches differ. Suppose that major frosts destroy the nation’s orange crop. The quantity of oranges produced falls to zero, and the price of the few oranges that remain on grocers’ shelves is driven sky-high. Because oranges are no longer part of GDP, the increase in the price of oranges does not show up in the GDP deflator. But because the CPI is computed with a fixed basket of goods that includes oranges, the increase in the price of oranges causes a substantial rise in the CPI.

Economists call a price index with a fixed basket of goods a Laspeyres index and a price index with a changing basket a Paasche index. Economic theorists have studied the properties of these different types of price indexes to determine which is a better measure of the cost of living. The answer, it turns out, is that neither is clearly superior. When prices of different goods are changing by different amounts, a Laspeyres (fixed basket) index tends to overstate the increase in the cost of living because it does not take into account the fact that consumers have the opportunity to substitute less expensive goods for more expensive ones. By contrast, a Paasche (changing basket) index tends to understate the increase in the cost of living. Although it accounts for the substitution of alternative goods, it does not reflect the reduction in consumers’ welfare that may result from such substitutions.

The example of the destroyed orange crop shows the problems with Laspeyres and Paasche price indexes. Because the CPI is a Laspeyres index, it overstates the impact of the increase in orange prices on consumers: by using a fixed basket of goods, it ignores consumers’ ability to substitute apples for oranges. By contrast, because the GDP deflator is a Paasche index, it understates the impact on consumers: the GDP deflator shows no rise in prices, yet surely the higher price of oranges makes consumers worse off.4

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In addition to the CPI and the GDP deflator, another noteworthy measure of inflation is the implicit price deflator for personal consumption expenditures, or PCE deflator. The PCE deflator is calculated like the GDP deflator but, rather than being based on all of GDP, it is based on only the consumption component of GDP. That is, the PCE deflator is the ratio of nominal consumer spending to real consumer spending.

The PCE deflator resembles the CPI in some ways and the GDP deflator in others. Like the CPI, the PCE deflator includes only the prices of goods and services that consumers buy; it excludes the prices of goods and services that are part of investment and government purchases. Also like the CPI, the PCE deflator includes the prices of imported goods. But like the GDP deflator, the PCE deflator allows the basket of goods to change over time as the composition of consumer spending changes. Because of this mix of attributes, the Federal Reserve uses the PCE deflator as its preferred gauge of how quickly prices are rising.

Luckily, the differences among these various measures of inflation are usually small in practice. Figure 2-3 shows inflation as measured by the CPI, the GDP deflator, and the PCE deflator for each year from 1948 to 2013. All three measures usually tell the same story about how quickly prices are rising.

Figure 2.4: FIGURE 2-3: Three Measures of Inflation This figure shows the percentage change in the CPI, the GDP deflator, and the PCE deflator for every year from 1948 to 2013. These measures of prices diverge at times, but they usually tell the same story about how quickly prices are rising. Both the CPI and the GDP deflator show that prices rose slowly in most of the 1950s and 1960s, that they rose much more quickly in the 1970s, and that they have risen slowly again since the mid-1980s.
Data from: U.S. Department of Commerce, U.S. Department of Labor.

Does the CPI Overstate Inflation?

The consumer price index is a closely watched measure of inflation. Policymakers in the Federal Reserve monitor it, along with many other variables, when setting monetary policy. In addition, many laws and private contracts have cost-of-living allowances, called COLAs, which use the CPI to adjust for changes in the price level. For instance, Social Security benefits are adjusted automatically every year so that inflation will not erode the living standard of the elderly.

Because so much depends on the CPI, it is important to ensure that this measure of the price level is accurate. Many economists believe that, for a number of reasons, the CPI tends to overstate inflation.

One problem is the substitution bias we have already discussed. Because the CPI measures the price of a fixed basket of goods, it does not reflect the ability of consumers to substitute toward goods whose relative prices have fallen. Thus, when relative prices change, the true cost of living rises less rapidly than does the CPI.

A second problem is the introduction of new goods. When a new good is introduced into the marketplace, consumers are better off because they have more products from which to choose. In effect, the introduction of new goods increases the real value of the dollar. Yet this increase in the purchasing power of the dollar is not reflected in a lower CPI.

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A third problem is unmeasured changes in quality. When a firm changes the quality of a good it sells, not all of the good’s price change reflects a change in the cost of living. The Bureau of Labor Statistics does its best to account for changes in the quality of goods over time. For example, if Ford increases the horsepower of a particular car model from one year to the next, the CPI will reflect the change: the quality-adjusted price of the car will not rise as fast as the unadjusted price. Yet many changes in quality, such as comfort or safety, are hard to measure. If unmeasured quality improvement (rather than unmeasured quality deterioration) is typical, then the measured CPI rises faster than it should.

Because of these measurement problems, some economists have suggested revising laws to reduce the degree of indexation. For example, Social Security benefits could be indexed to CPI inflation minus 1 percent. Such a change would provide a rough way of offsetting these measurement problems. At the same time, it would automatically slow the growth in government spending.

In 1995, the Senate Finance Committee appointed a panel of economists to study the magnitude of the measurement error in the CPI. The panel concluded that the CPI was biased upward by 0.8 to 1.6 percentage points per year, with their “best estimate” being 1.1 percentage points. This report led to some changes in the way the CPI is calculated, so the bias is now thought to be under 1 percentage point. The CPI still overstates inflation, but not by as much as it once did.5

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