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How changes in the cost of living are measured

How is inflation measured? What is the consumer price index?

Key points

  • The Consumer Price Index, or CPI is a measure of inflation calculated by US government statisticians based on the price level from a fixed basket of goods and services that represents the purchases of the average consumer.
  • The core inflation index is a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices.
  • The quality/new goods bias causes inflation calculated using a fixed basket of goods over time to overstate the true rise in cost of living because improvements in the quality of existing goods and the invention of new goods are not taken into account.
  • The substitution bias causes an inflation rate calculated using a fixed basket of goods over time to overstate the true rise in the cost of living because it does not take into account that people can substitute away from goods whose prices rise disproportionately.
  • Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all the components of GDP. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. The Employment Cost Index measures wage inflation in the labor market. The International Price Index is based on the prices of merchandise that is exported or imported.

How changes in the cost of living are measured

The most commonly cited measure of inflation in the United States is the Consumer Price Index, or CPI. The CPI is calculated by government statisticians at the US Bureau of Labor Statistics based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four.
In recent years, these statisticians have paid considerable attention to a subtle problem: the change in the total cost of buying a fixed basket of goods and services over time is conceptually not quite the same as the change in the cost of living because the cost of living represents how much it costs for a person to feel that his or her consumption provides an equal level of satisfaction or utility.
To understand the distinction, imagine that over the past 10 years, the cost of purchasing a fixed basket of goods increased by 25% and your salary also increased by 25%. Has your personal standard of living held constant?
If you do not necessarily purchase an identical fixed basket of goods every year, then an inflation calculation based on the cost of a fixed basket of goods may be a misleading measure of how your cost of living has changed. Two problems arise here: substitution bias and quality/new goods bias.
When the price of a good rises, consumers tend to purchase less of it and to seek out substitutes instead. Conversely, as the price of a good falls, people will tend to purchase more of it. This pattern implies that goods with generally rising prices should tend over time to become less important in the overall basket of goods used to calculate inflation, while goods with falling prices should tend to become more important.
Consider, as an example, a rise in the price of peaches by $100 per pound. If consumers were utterly inflexible in their demand for peaches, this would lead to a big rise in the price of food for consumers. Alternatively, imagine that people are utterly indifferent to whether they have peaches or other types of fruit. Now, if peach prices rise, people will completely switch to other fruit choices and the average price of food will not change at all.
A fixed, unchanging basket of goods assumes that consumers are locked into buying exactly the same goods, regardless of price changes—not a very likely assumption. Substitution bias tends to overstate the rise in a consumer’s true cost of living because it does not take into account that the person can substitute away from goods whose relative prices have risen.
The other major problem in using a fixed basket of goods as the basis for calculating inflation is how to deal with the arrival of improved versions of older goods or altogether new goods. Consider the problem that arises if a cereal is improved by adding 12 essential vitamins and minerals but costs 5% more per box. It would be misleading to count the entire resulting higher price as inflation because the new price is being charged for a product of higher—or at least different—quality. Ideally, we would like to know how much of the higher price is due to the quality change and how much of it is just a higher price. The Bureau of Labor Statistics, or BLS, which is responsible for the computation of the Consumer Price Index, or CPI—a measure of inflation calculated based on the price level from a fixed basket of goods and services that represents the purchases of the average consumer—must deal with these difficulties in adjusting for quality changes.
A new product can be thought of as an extreme improvement in quality—from something that did not exist to something that does. However, the basket of goods that was fixed in the past obviously does not include new goods created since then. The basket of goods and services used in the CPI is revised and updated over time, so new products are gradually included. But the process takes some time.
For example, room air conditioners were widely sold in the early 1950s but were not introduced into the basket of goods behind the CPI until 1964. VCRs and personal computers were available in the late 1970s and widely sold by the early 1980s, but they did not enter the CPI basket of goods until 1987. By 1996, there were more than 40 million cellular phone subscribers in the United States, but cell phones were not yet part of the CPI basket of goods. The parade of inventions has continued, with the CPI inevitably lagging a few years behind.
The arrival of new goods creates problems with respect to the accuracy of measuring inflation as well. The reason people buy new goods, presumably, is that the new goods offer better value for money than existing goods. Thus, if the CPI leaves out new goods, it overlooks one of the ways in which the cost of living is improving. In addition, the price of a new good is often higher when it is first introduced and then declines over time. If the new good is not included in the CPI for some years—until its price is already lower—the CPI may miss counting this price decline altogether.
Taking these arguments together, the quality/new goods bias means that the rise in the price of a fixed basket of goods over time tends to overstate the rise in a consumer’s true cost of living because it does not take into account how improvements in the quality of existing goods and the invention of new goods improve the standard of living.

The Consumer Price Index and core inflation index

Imagine you're driving a company truck across the country—you probably would care about things like the prices of available roadside food and motel rooms as well as the truck’s operating condition. However, the manager of the firm might have different priorities. They would care mostly about the truck’s on-time performance and much less about the driver's food and motel. In other words, the company manager would be paying attention to the production of the firm, while ignoring transitory elements that impact the driver but don't affect the company’s bottom line.
In a sense, a similar situation occurs with regard to measures of inflation. As we’ve learned, CPI measures prices as they affect everyday household spending. The core inflation index is a little different—it is typically calculated by taking the CPI and excluding volatile economic variables. In this way, economists have a better sense of the underlying trends in prices that affect the cost of living.
Examples of excluded variables include energy and food prices, which can jump around from month to month because of the weather. According to an article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply point for the nation’s gasoline was nearly knocked out. Gas prices quickly shot up across the nation, in some places up to 40 cents a gallon in one day. This was not caused by economic policy but was the result of a a short-lived event. In this case, the CPI that month would register the change as a cost of living event to households, but the core inflation index would remain unchanged. As a result, the Federal Reserve’s decisions on interest rates would not be influenced. Similarly, droughts can cause worldwide spikes in food prices that, if temporary, do not affect the nation’s economic capability.
As former Chairman of the Federal Reserve Ben Bernanke noted in 1999 about the core inflation index, “It provide(s) a better guide to monetary policy than the other indices, since it measures the more persistent underlying inflation rather than transitory influences on the price level.” Bernanke also noted that the core inflation index helps communicate that every inflationary shock need not be responded to by the Federal Reserve since some price changes are transitory and not part of a structural change in the economy.
In sum, both the CPI and the core inflation index are important, but they serve different audiences. The CPI helps households understand their overall cost of living from month to month, while the core inflation index is the preferred gauge by which to make important government policy changes.

Practical solutions for substitution and quality/new goods biases

By the early 2000s, the BLS was using alternative mathematical methods for calculating the Consumer Price Index that were more complicated than just adding up the cost of a fixed basket of goods in order to allow for some substitution between goods. The BLS was also updating the basket of goods behind the CPI more frequently so that new and improved goods could be included more rapidly.
For certain products, the BLS was carrying out studies to try to measure the quality improvement. For example, with computers, an economic study can try to adjust for changes in speed, memory, screen size, and other characteristics of the product and then calculate the change in price after these product changes are taken into account. But these adjustments are inevitably imperfect, and exactly how to make these adjustments is often a source of controversy among professional economists.
By the early 2000s, the substitution bias and quality/new goods bias had been somewhat reduced. Since then, the rise in the CPI probably overstates the true rise in inflation by only about 0.5% per year. Over one or a few years, this is not much; over a period of a decade or two, though, even half of a percent per year compounds to a more significant amount. In addition, the CPI tracks prices from physical locations and not from online sites like Amazon, where prices can be lower.
When measuring inflation—and other economic statistics, too—a tradeoff arises between simplicity and interpretation. If the inflation rate is calculated with a basket of goods that is fixed and unchanging, then the calculation of the inflation rate is straightforward, but the problems of substitution bias and quality/new goods bias arise. However, when the basket of goods is allowed to shift and evolve to reflect substitution toward lower relative prices, quality improvements, and new goods, the technical details of calculating the inflation rate grow more complex.

Additional price indices

The basket of goods behind the Consumer Price Index represents an average hypothetical US household, which is to say that it does not exactly capture anyone’s personal experience. When the task is to calculate an average level of inflation, this approach works fine. What if, however, you are concerned about inflation experienced by a certain group, like elderly people, people living in poverty, single-parent families with children, or Latino people? In specific situations, a price index based on the buying power of the average consumer may not feel quite right.
This problem has a straightforward solution. If the CPI does not serve the desired purpose, then invent another index, based on a basket of goods appropriate for the group of interest. Indeed, the BLS publishes a number of experimental price indices—some for particular groups like people living in poverty, some for different geographic areas, and some for certain broad categories of goods like food or housing.
The BLS also calculates several price indices that are not based on baskets of consumer goods. For example, the Producer Price Index, or PPI, is based on prices paid for supplies and inputs by producers of goods and services. It can be broken down into price indices for different industries, commodities, and stages of processing—like finished goods, intermediate goods, and crude materials for further processing.
There is an International Price Index based on the prices of merchandise that is exported or imported. An Employment Cost Index measures wage inflation in the labor market. The GDP deflator—measured by the Bureau of Economic Analysis—is a price index that includes all the components of GDP. MIT's Billion Prices Project is a more recent alternative attempt to measure prices: data are collected online from retailers and then composed into an index that is compared to the CPI.
What’s the best measure of inflation? If you're concerned with the most accurate measure of inflation, use the GDP deflator since it picks up the prices of goods and services produced. Remember, though, that the GDP deflator is not a good measure of cost of living as it includes prices of many products not purchased by households—aircraft, fire engines, factory buildings, office complexes, and bulldozers, among others.
If you want the most accurate measure of inflation as it impacts households, use the CPI since it only picks up prices of products purchased by households—which is why the CPI is sometimes referred to as the cost-of-living index. As the BLS states on its website: “The ‘best’ measure of inflation for a given application depends on the intended use of the data.”

Summary

  • The Consumer Price Index, or CPI is a measure of inflation calculated by US government statisticians based on the price level from a fixed basket of goods and services that represents the purchases of the average consumer.
  • The core inflation index is a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices.
  • The quality/new goods bias causes inflation calculated using a fixed basket of goods over time to overstate the true rise in cost of living because improvements in the quality of existing goods and the invention of new goods are not taken into account.
  • The substitution bias causes an inflation rate calculated using a fixed basket of goods over time to overstate the true rise in the cost of living because it does not take into account that people can substitute away from goods whose prices rise disproportionately.
  • Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all the components of GDP. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. The Employment Cost Index measures wage inflation in the labor market. The International Price Index is based on the prices of merchandise that is exported or imported.

Self-check questions

Which of the price indices introduced in this article would be most useful for adjusting your paycheck for inflation?
The Consumer Price Index is subject to substitution bias and quality/new goods bias. Are the Producer Price Index and the GDP Deflator also subject to these biases? Why or why not?

Review questions

  • Why does substitution bias arise if the inflation rate is calculated based on a fixed basket of goods?
  • Why does the quality/new goods bias arise if the inflation rate is calculated based on a fixed basket of goods?

Critical-thinking questions

  • Given the federal budget deficit in recent years, some economists have argued that by adjusting Social Security payments for inflation using the CPI, Social Security is overpaying recipients. What is the argument being made, and do you agree or disagree with it?
  • Why is the GDP deflator not an accurate measure of inflation as it impacts a household?
  • Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias?

Want to join the conversation?

  • leafers ultimate style avatar for user likawhatever
    It would be nice if these questions would be turned into exercises like the math section. Because, then you'd know for sure if the answer is right. Just a thought.
    (26 votes)
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  • mr pink green style avatar for user Keawe- Caspillo, Jaedyn
    Which of the following best describes what is necessary for consumers to maintain the same standard of living over time if there is inflation?
    (9 votes)
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  • blobby green style avatar for user lifeofangel7
    Hi... how will it matter if the basket is updated every 5 years or say 4 years.... what effect it would have both positive and negative?
    (4 votes)
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    • leafers ultimate style avatar for user likawhatever
      Because less substitution for different goods will be made. And there will be less new goods, i.e. the iPad first came out in 2010, 10 years from today (2007) would not account for tablets and such. Even smartphones and iPhone didn't exist then. But 5 years, putting us to 2012 would account for more new goods and have less substitution bias and quality/new goods bias.
      (6 votes)
  • blobby green style avatar for user willrobinson87
    Why do they say CPI doesn't account for the quality/new goods bias? Why should it, we cant still buy a black and white CRT TV, the price of a modern TV (albeit with a larger better quality screen) is just the price of a modern TV and CPI absolutely should reflect fully this price? It is a measure of Prices, not standard of living? Also many modern goods have a shorter lifespan than older goods, when it comes to complex electronics or even things like an Iron? My grandmother still uses her 1970s iron, while I have had to replace my Iron 3 times in my short few years of being an Iron user.
    (3 votes)
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    • starky tree style avatar for user melanie
      It should reflect it if we want a totally accurate measure. The examples you cite are exactly why it should. Is the iron I have to replace every year really the same good as your grandmother's? No, its not. But the CPI considers it to be the same thing, and that leads to inaccuracies.
      (4 votes)
  • leafers seed style avatar for user Allan
    Review Question 1: The substitution bias causes an inflation rate calculated using a fixed basket of goods over time to overstate the true rise in the cost of living because it does not take into account that people can substitute away from goods whose prices rise disproportionately.

    Review Question 2: The quality/new goods bias causes inflation calculated using a fixed basket of goods over time to overstate the true rise in cost of living because improvements in the quality of existing goods and the invention of new goods are not taken into account.

    Critical-thinking Question 1: The argument being made is that Social Security is overpaying recipients because it is adjusting for inflation. I disagree with it.

    Critical-thinking Question 2: The GDP deflator is not an accurate measure of inflation as it impacts a household because it also includes things that households don't normally buy such as aircraft.

    Critical-thinking Question 3: It won't affect the amount of substitution bias and quality/new goods bias unless they factor it in
    (1 vote)
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  • blobby green style avatar for user Mukilan sethuraman
    is CPI includes the taxes payed by the household for using government services?
    (1 vote)
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  • blobby green style avatar for user Mukilan sethuraman
    "GDP deflator is not a good measure of cost of living as it includes prices of many products not purchased by households—aircraft, fire engines, factory buildings, office complexes, and bulldozers, among others."
    but is this true as the household are dependent on this through various ways as employment,security provided by govt,transportation....etc
    (1 vote)
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  • blobby green style avatar for user lifeofangel7
    Why government expenditure is always accounted against total GDP of the country e.g. health expenditure of country x is 2% of its GDP. Should not we relate government expenditure with its revenue e.g. Government of country x spends 10% of its total budget/revenue on health. What is the connecting link between government expenditure and total production (GDP) of an economy?
    (1 vote)
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