Economics Online Tutor
|What is a
Why is it
By Jerry Wyant
April 11, 2013
First, some background concerning inflation and price indexes:
Prices and wages do not all move together: at the same rate, at the same
time, or even always in the same direction. This means that during any
specific time frame, inflation will affect different people in varying degrees.
Price indexes have been developed as an attempt to measure the average
effect of inflation on different groups of people. Changes in consumer prices
are measured using an index called the CPI.
Given that the economy is large and complex, these measurements are
estimates; they are attempts at measuring average, not actual, effects on
individuals within a group. The CPI is a calculation by the Bureau of Labor
Statistics, a calculation which measures price changes in what is considered
to be a “typical” bundle of goods purchased by a “typical” household in a
given period of time.
The CPI is a measurement of the loss of purchasing power due to inflation for
a specific dollar amount of income for consumers. The loss of purchasing
power for people on a “fixed” income can be offset by tying the income of
these people to the CPI. That is the purpose; that is the theory behind cost of
living increases (COLAs) for people who rely on Social Security benefits for
their living expenses.
The CPI is a flawed measurement, for a number of reasons:
1. As mentioned above, it is only an estimate of an average.
2. The CPI is not adjusted for different spending patterns of different individuals, and especially for
differences in spending among different demographic groups. There is no such thing as a “typical”
household that spends income according to a predetermined “typical” bundle of goods. Of specific
interest here, the demographic groups that comprise those who rely on Social Security benefits tend to
have spending patterns that are far different from other demographic groups that are used in the CPI
calculations. Many people believe that senior citizens tend to lose purchasing power over time due to a
downward bias in the CPI calculations for this demographic group.
3. Using one measurement, whether it is the CPI or some other measurement, can never be accurate
because of the difference between something called “core inflation” and something called “headline
inflation”. Certain items that tend to make up a large percentage of many people’s spending patterns,
such as food and energy, tend to have volatile price changes relative to other price changes. Over
longer periods of time, these “headline” items tend to have price changes that are similar to other
“core” items; but in the short run, price changes for the headline items are much more volatile. When
gasoline prices go up quickly, or even when meat prices go up, headline inflation is much higher than
core inflation. But at other times, headline inflation is much lower than core inflation, to the extent that
overall headline inflation can be negative (deflation) while core inflation is positive. The differences
between the “headline” and “core” measurements of inflation in any given time period have different
implications depending on the context of what the measurements are being used for. For example,
monetary policy based on headline inflation measurements would be very volatile and could further
destabilize the economy. For this reason, the CPI only measures core inflation. People who rely on Social
Security benefits tend to spend a relatively large percentage of income on headline items, leading to
charges that the formula used to calculate COLAs for people on Social Security lead to a decrease in
purchasing power for seniors; that inflation is understated for these people, especially during times of
rising gasoline prices.
4. Over time, product quality tends to change due to new technology and the introduction of new
features on existing products. Many things become “new and improved” and today’s products may be
vastly different from their counterparts from yesteryear. The CPI index does not take into consideration
that these added features mean that consumers may get more out of each product. The CPI does not
measure how much of a price change is due to different features, and how much is due to a decrease in
purchasing power. It treats all price increases as inflation and ignores the improvements. This works the
other way, also. Some products are manufactured to be inferior to yesterday’s versions. But overall,
most economists consider the CPI to overstate inflation because it ignores technological improvements.
5. Another form of upward bias is known as the substitution effect. The CPI measurement over time is
based on prices in a constant “typical bundle” of goods. However, when some prices tend to increase
over time much more than other prices, people in the aggregate will spend less of their incomes on the
products with the highest price increases, and spend more of their incomes on products with price
decreases or at least lower price increases. Since the CPI uses only a constant bundle, regardless of the
differences in individual price changes, it will overstate inflation by the magnitude of the substitution
effect. Differences of opinion exist regarding the size of the substitution effect.
What is the Chained-CPI?
The Chained-CPI has been developed as an attempt to remove the upward bias due to the substitution
effect as described in #5 above. Basically, it uses a “chained” bundle instead of a “fixed” bundle of
goods in order to measure inflation. Up until now, a Chained-CPI has not been used as part of
government policy. However, it is currently on the table in the budget negotiations. Thus the current
increase in public interest.
The controversies? Just as the CPI is flawed because it uses estimates of what is “typical”, the Chained-
CPI takes these estimates to another level, making their accuracy even more “iffy”. One reason why the
Chained-CPI has not been adopted before now is the lack of confidence in its accuracy.
Although it has not been used in policy before now, the Chained-CPI has been tracked for some time. It
clearly does provide a lower measure of inflation than the standard CPI currently in use. This lower
inflation measure is important, because the Chained-CPI is being considered for calculating COLA’s for
Social Security benefits. A switch would clearly lead to lower future benefits for Social Security
recipients. The argument in favor of switching to a Chained-CPI includes the upward bias of the
substitution effect, as explained in #5 above. The argument is that adjustments for inflation are too high
because the CPI overstates inflation. The counter-argument is that the people who are being targeted
(Social Security recipients) already are facing decreasing purchasing power due to the points made in #2
and #3 above. According to this argument, the downward bias of the CPI, especially for the targeted
senior citizens, far outweighs the upward bias due to a substitution effect that is not demographic-
specific. Social Security benefits are already low for these reasons, and a switch to a Chained-CPI would
make them even lower. Lower purchasing power and lower standards of living for our senior citizens
would result. People who have paid into the system for decades would lose benefits that they have paid
One more area of controversy: The debate over the Chained-CPI is included in the debate over the
federal budget, even though Social Security is not part of the general budget; Social Security is a
separate fund with separate funding. Combining a debate over Social Security with a debate over the
general budget confuses the issue, creating potential for misinformation in the public and in the media.
A decrease in benefits has been tied to the debate over the future solvency of the Social Security
system, and the urgency and wisdom of “doing something about it” now. But in its current form, that is
not the issue being debated. The health of the Social Security system is an issue that involves much
more than what is being discussed today. Instead of debating that issue and all of its specific
complexities, a decrease in future Social Security benefits has been inserted into a largely unrelated
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