Inflation & Index NumbersProblems & Issues

Dr. D. Foster – ECO 285 – Spring 2014

Substitution BiasSubstitution Bias

• ““Lower level”Lower level”– Consumers substitute across brands.– Increase price of Whopper but not Big Mac and

people buy more Big Macs.– This is “mimicked” by CPI-U since 2002 due to its

use of geometric means.• ““Upper level”Upper level”– Substitution across categories.– Price of chicken rises and people buy more pork.– This is incorporated into the C-CPI-U calculation.

Quality BiasQuality Bias

• If quantifiable, easy to include.If quantifiable, easy to include.– Candy bar falls from 8 oz. to 6 oz. while price stays

at $.50.– Will be recorded as $.67 and add to inflation.

• If not quantifiable …If not quantifiable …– Just guessing.– Gas additive example.– Based on hedonic pricing techniques.– We aren’t recording real $ values.

New Product BiasNew Product Bias• Incompatible with fixed basket of goods.• By the time it is included, its price has fallen!!• CPI-U and CPI-W update baskets every 2 years.• C-CPI-U updates basket every month.

Outlet/Distribution BiasOutlet/Distribution Bias

• Not every price is recorded.• Prices differ depending on location & store.• If Sam’s Club is missed, low end not

represented.• Today, web purchases would further

complicate this aspect.

Other BiasesOther Biases

• Small Sample BiasSmall Sample Bias– When only a few observations are recorded for an

item & the geometric mean is derived.– Calculated value is overstated.

• Rental Equivalence BiasRental Equivalence Bias– The value of owner occupied homes – what they

would rent for.– You can’t presume this would be the market rent.

What are we measuring?What are we measuring?

• Callahan: Gibberish• The thermometer analogy.

1980

2014

$25/hour $75/hour

Is there inflation?If programmers today are 2, 3, 4 times as productive today …

* 2 =

$37.50/hr

* 3 =

$25/hour

* 4 =

$18.75/hr

It gets worse …It gets worse …

• Did prices rise in 2014? Did they fall?• We still can’t tell, because prices measure

value!!!!– We increase demand, price rises.We increase demand, price rises.– We decrease demand, price falls.We decrease demand, price falls.

$.50 2013 $1.00 2014 $.25 2014

Individuals – the ultimate biasIndividuals – the ultimate bias

• You don’t buy what is in the basket.• You don’t buy the same proportion as

the basket.• Establishing one single number for

“inflation” is meaningless.• Inflation is the ultimate individual

statistic.

These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred… [T]hey provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell.

Last word - CallahanLast word - Callahan

I have no objection to measuring anything that can I have no objection to measuring anything that can meaningfully measured. However, the problem with meaningfully measured. However, the problem with price indices is not that they are inaccurate, but that price indices is not that they are inaccurate, but that

the idea of a price index can't even be defined the idea of a price index can't even be defined coherently. Moreover, such indices are used to justify coherently. Moreover, such indices are used to justify any amount of economic tinkering on the part of the any amount of economic tinkering on the part of the

government, whereby it displays its ability to "control" government, whereby it displays its ability to "control" numbers that are its own arbitrary creation. The most numbers that are its own arbitrary creation. The most beneficial change that the government could initiate in beneficial change that the government could initiate in

this field would be to fire all its econometricians, this field would be to fire all its econometricians, lowering the "price level" of our taxes.lowering the "price level" of our taxes.

The Effects of The Effects of InflationInflation

• If unexpected:If unexpected:– Recipients of fixed incomes are losers . . .– Payers of fixed amounts are winners . . . – Real interest returns fall (r = i - %cpi).

• If expected . . . it shouldn’t matter, If expected . . . it shouldn’t matter, but:but:– Repricing costs (less now with scanners).– Inconvenience costs if money holdings fall.– Real economic costs if workers want

compensation for the uncertainty.– If high, to pull it down requires a recession

and an increase in unemployment.

Inflation & Index NumbersProblems & Issues

Dr. D. Foster – ECO 285 – Spring 2014