Inflation & Index Numbers Problems & Issues

1. Inflation & Index NumbersProblems & Issues Dr. D. Foster – ECO 285 – Spring 2014

2. Substitution Bias • “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” • Substitution across categories. • Price of chicken rises and people buy more pork. • This is incorporated into the C-CPI-U calculation.

3. Quality Bias • 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 … • Just guessing. • Gas additive example. • Based on hedonic pricing techniques. • We aren’t recording real $ values.

4. New 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.

5. Outlet/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.

6. Other Biases • Small Sample Bias • When only a few observations are recorded for an item & the geometric mean is derived. • Calculated value is overstated. • Rental Equivalence Bias • The value of owner occupied homes – what they would rent for. • You can’t presume this would be the market rent.

7. What are we measuring? • Callahan: Gibberish • The thermometer analogy. 2014 * 2 = * 3 = * 4 = 1980 $75/hour $37.50/hr $25/hour $18.75/hr $25/hour Is there inflation? If programmers today are 2, 3, 4 times as productive today …

8. 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 decrease demand, price falls. $.50 2013 $1.00 2014 $.25 2014

9. Individuals – the ultimate bias • You don’t buy what is in the basket. • You don’t buy the same proportion asthe basket. • Establishing one single number for“inflation” is meaningless. • Inflation is the ultimate individualstatistic. 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.

10. Last word - Callahan I have no objection to measuring anything that can meaningfully measured. However, the problem with price indices is not that they are inaccurate, but that the idea of a price index can't even be defined coherently. Moreover, such indices are used to justify any amount of economic tinkering on the part of the government, whereby it displays its ability to "control" numbers that are its own arbitrary creation. The most beneficial change that the government could initiate in this field would be to fire all its econometricians, lowering the "price level" of our taxes.

11. The Effects of Inflation • 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, 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.

12. Inflation & Index NumbersProblems & Issues Dr. D. Foster – ECO 285 – Spring 2014