## Shortcomings of CPI March 14, 2011

Posted by tomflesher in Macro, Teaching.
Tags: , , , , , , ,

In the previous post, we talked about the Consumer Price Index (CPI). Basically, the CPI is a number that indicates how much the price of a basket of goods purchased by the typical consumer has changed since a base year we choose when we calculate it. To review, in the base year, CPI is always 100, and in other years a number greater than 100 indicates that prices are higher than the base year while a number less than 100 indicates that the price level is lower than the base year.

One way to measure inflation is just by calculating the change in CPI. The percentage change in CPI – $\% \Delta CPI$ – can be calculated by figuring the year you’re interested in as the base year and then just subtracting 100 from the current CPI. However, if you’re using other data where the base year is already calculated (such as from FRED), you can use the regular percentage change formula:

$\%\Delta CPI = \frac{CPI_{current} - CPI_{base}}{CPI_{base}}$

However, the nature of the CPI leads to a few problems. They stem from the use of the basket of goods, which has to stay constant from one year to another in order for the comparisons to be meaningful. That means that whatever we decide to use as the basket of goods in 2007 has to be what we calculate the value of in 2011. There are some immediate problems that come to mind.

First, think about the changes in relative prices of goods to each other. Let’s say the basket contains a pound of flank steak. A lot of people use that as the filling for tacos, so a substitute good might be roast pork. If those goods are around the same price, people are indifferent between them. What if the price of pork increases a little, but the price of flank doubles? In that case, a lot of people will stop buying flank steak and switch over to pork instead. The basket doesn’t reflect this, though, so the CPI will rise a lot more than the relative cost of living does, so the CPI doesn’t really accurately reflect the change in the cost of buying what a typical household buys. This is called substitution bias.

Second, I’m addicted to my iPad. When the current basket was created in 2007, it didn’t exist. Now, it’s practically a requirement for a grad student. The basket can’t account for the introduction of new goods like this, since in order for it to be a useful comparison, the basket has to stay the same from year to year.

Finally, I think it’s fair to say that some goods are getting more durable. An iPod Touch, for example, lasts longer than it did when it was introduced in 2007. It offers more features than it used to (such as voice control and a camera). Even if prices had stayed the same,  fourth-generation Touch is worth far more than a first-generation Touch. The same expenditure generates a lot more happiness, and so the quality of goods isn’t accounted for in the CPI.

CPI isn’t a perfect measure of inflation or the cost of living, but it’s a common and important one. Know how to calculate it, and know its shortcomings.