The biases of CPI

  1. 4 Bias of CPI
    • New Goods Bias
    • Quality Change Bias
    • Commodity Substitution Bias
    • Outlet Substitution Bias
  2. Magnitude & Consequences of the Bias
    • Magnitude of the Bias
    • Overstate of Inflation by 1.1% a year
    • Consequences of the Bias
    • Private Contracts and Government Outlays
  3. Alternatives to CPI
    • Chained CPI
    • Personal Consumption Expenditure Deflator
    • GDP Deflator
Topic Notes

4 Biases of CPI

New Goods Bias: Goods like TVs and digit cameras decrease significantly right after their introduction. If this happens before the consumer basket is updated to include the new goods, then the CPI will overstate the true cost of living.

Quality Change Bias: Quality of goods like cars get better every year. The rise of the prices of these goods are because of its improved qualities, and not inflation. However, CPI treats this price increase as inflation, and overstates it.

Commodity Substitution Bias: Changes in prices of goods lead consumers to buy other goods. For example, if the apples are more expensive and the prices of oranges are unchanged, then people will buy more oranges. The switch between apples and oranges may provide the same amount of fruit and the price of fruits has stayed the same, but CPI ignores the substitution and says the price of fruits has increased.

Outlet Substitution Bias: When the prices of goods are high, people may use discount stores more often rather than convenience stores. The CPI does not account for this.

Magnitude & Consequences of the Bias

Magnitude of the Bias: Keeping these biases and maybe other unknown biases in mind, the CPI overstates inflation by 1.1% a year (measured by a Congressional Advisory Commission in 1996).

For example, if the CPI report an inflation of 2.1% a year, then the actual inflation rate is 1% a year.

Consequences of the Bias:
  1. Private Contracts: some wage contracts are linked to CPI. For example, the company and the worker may agree on an increase in wage of 2% a year plus the percent increase in the CPI. If CPI is overstated, then the company will pay more to the worker than intended.
  2. Government Outlays: a third of federal government outlays are directly linked to CPI. A bias of 1.1% a year that goes on for a decade can add up to trillion dollars of additional expenditures

Alternatives to CPI

Since there are a lot of biases for CPI, there are some alternative prices indexes we can use to accommodate for it.

Chained CPI: a price index that incorporates substitution and new goods bias by using current and previous period quantities, rather than fixed quantities from an earlier period.

Personal Consumption Expenditure (PCE) Deflator: a price index that has a basket of goods and services that is broader than CPI. This is because it also includes all consumption expenditures, rather than the items bought by a typical urban family. To calculate the PCE deflator, we use the following formula:

PCB deflator = Nominal  CReal  C×x100\frac{Nominal\;C} {Real\;C} \, \times x100

where C Cis the personal consumption expenditure.

GDP Deflator: a price index that includes all goods and services which are part of GDP. Essentially, it includes the price index of consumption expenditure, investment expenditure, government expenditure, and net exports.

To calculate the GDP Deflator, we use the following formula:

GDP deflator = Nominal  CReal  GDP×x100\frac{Nominal\;C} {Real\;GDP} \, \times x100