I N T O U C H W I T H D ATA A N D R E S E A R C H
Does CPI Inflation Overstate Increases in the Cost of Living?
In 1995-1996 a government commission, headed by Michael Baskin of Stanford University, prepared a report on the accuracy of official inflation measures. The commission concluded that inflation as measured by the CPI may overstate true increases in the cost of living by as much as 1-2 percentage points per year. In other words, if the official inflation rate is 3°/o per year, the "true" inflation rate may well be only 1 °/o-2°/o per year.
Why might increases in the CPI overstate the actual rate at which the cost of living rises? One reason is the difficulty that government statisticians face in trying
to measure changes in the quality of goods. For example, if the design of an air con ditioner is improved so that it can put out 10°/o more cold air without an increased use of electricity, then a 10°/o increase in the price of the air conditioner should not be considered inflation; although paying 10°/o more, the consumer is also receiving
10°/o more cooling capacity. However, if government statisticians fail to account for the improved quality of the air conditioner and simply note its 10°/o increase in price, the price change will be incorrectly interpreted as inflation.
Although measuring the output of an air conditioner isn't difficult, for some products (especially services) quality change is hard to measure. For example, by what percentage does the availability of 24-hour cash machines improve the qual
ity of banking services? To the extent that the CPI fails to account for quality improvements in the goods and services people use, inflation will be overstated. This overstatement is called the quality adjustment bias.
Another problem with CPI inflation as a measure of cost of living increases can be illustrated by the following example. Suppose that consumers like chicken and
Chapter 2 The Measurement and Structure of the National Economy 47
then for some reason the price of chicken rises sharply, leading consumers to switch to eating turkey almost exclusively. Because consumers are about equally satisfied with chicken and turkey, this switch doesn't make them significantly worse off; their true cost of living has not been affected much by the rise in the price of chick en. However, the official CPI, which measures the cost of buying the base-year basket of goods and services, will register a significant increase when the price of
chicken skyrockets. Thus the rise in the CPI exaggerates the true increase in the cost of living. The problem is that the CPI is based on the assumption that consumers purchase a basket of goods and services that is fixed over time, ignoring the fact
that consumers can (and do) substitute cheaper goods or services for more expen sive ones. This source of overstatement of the true increase in the cost of living is called the substitution bias.
If official inflation measures do, in fact, overstate true inflation, there are impor tant implications. First, if cost of living increases are overstated, then increases in important quantities such as real family income (the purchasing power of a typical family's income) are correspondingly understated. As a result, the bias in the CPI may lead to too gloomy a view of how well the U.S. economy has done over the past few decades. Second, many government payments and taxes are tied, or
indexed, to the CPl. Social Security benefits, for example, automatically increase each year by the same percentage as the CPl. If CPI inflation overstates true inflation, then Social Security recipients have been receiving greater benefit increas
es than necessary to compensate them for increases in the cost of living. If Social Security and other transfer program payments were set to increase at the rate of "true" inflation, rather than at the CPI inflation rate, the Federal government would save billions of dollars each year.
In response to the Baskin commission's report, the Bureau of Labor Statistics (BLS) made several technical changes in the way it constructs the CPI to reduce substitution bias. These changes have reduced the overstatement of the "true" inflation rate by 0.2 to 0.4 percentage points per year. However, the substitution bias was originally larger than the Baskin Commission's estimate, so the bias in the
inflation rate is still 1 °/o per year, or perhaps even higher.
Note: For a detailed discussion of biases in the CPI, see David Lebow and Jeremy Rudd, "Measure
ment Error in the Consumer Price Index: Where Do We Stand?" Journal of Economic Literature, March
2003, pp. 159-201; and Robert J. Gordon, "The Boskin Commission Report: A Retrospective One Decade Later," NBER Working Paper No. 12311, June 2006.
Inflation. An important variable that is measured with price indexes is the
inflation rate. The inflation rate equals the percentage rate of increase in the price index per period. Thus, if the GDP deflator rises from 100 in one year to 105 the next, the inflation rate between the two years is (105 - 100) /100 = 5/100 = 0.05 = 5°/o per year. If in the third year the GDP deflator is 112, the inflation rate between the
second and third years is (112 - 105)/ 105 = 7/ 105 = 0.0667 = 6.67°/o per year. More generally, if Pt is the price level in period t and Pt+l is the price level in period t + 1, the inflation rate between t and t + 1, or 1Tt+l, is
48 Part 1 Introduction
Figure 2.1
The inflation rate in the United States,
1960-2008
Here, inflation is mea
sured as the annual per centage change in the
GDP deflator. Inflation rose during the 1960s
and 1970s, fell sharply in the early 1980s, and fell more in the 1990s, but had an upward trend in the first half of the 2000s before declining later in the decade.
Source: Implicit price deflator for GDP, from FRED database, Federal Reserve Bank of St.
Louis, research.stlouisfed.org/ fred2/series/G D PCTP I. 6 1 U .S. I N F LATION RATE 1 960 1 964 1 968 1 97 2 1 976 1 980 1 984 1 988 1 992 1 996 2000 2 004 2008 Year
where ilPt+l, or Pt+l - Pt, represents the change in the price level from date t to
date t + 1 .
Figure 2.1 shows the U.S. inflation rate for 1960-2008, based on the GDP defla tor as the measure of the price level. Inflation rose during the 1960s and 1970s, fell
sharply in the early 1980s, fell more in the 1990s, trended upward from 1998 to 2005, and declined from 2005 to 2008.