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