The Consumer Price Index
April 1, 1996
The Consumer Price Index (CPI) is a commonly-used government statistic that measures changes in the level of prices for goods and services. The accuracy of the CPI is important because it is used to calculate federal benefits and to project revenue and spending However, economists generally agree that it overstates the extent of price rises, and that these errors are compounded over time.
Last year, experts who studied the CPI for the Senate Finance Committee reported this upward bias has been between 1.3 percent and 1.7 percent for several years. The Advisory Commission to Study the CPI reported five ways in which it overstates prices. Based on evidence from research, it is possible to estimate the amount of overstatement.
- Consumers substitute cheaper goods for more expensive ones when prices rise, but the CPI uses a fixed basket of goods -- overstating prices by 0.2 percent a year.
- The method used to put price quotations together for an overall estimate has an upward bias of 0.5 percent a year.
- Consumers may switch to discounters rather than higher-priced stores for the same goods, but the CPI ignores this, biasing the CPI by 0.25 percent to 0.4 percent a year.
- The CPI doesn't reflect the effect on prices of new varieties or models of existing goods and the growing number of choices consumers have due to new product types, causing an estimated bias of 0.35 percent to 0.6 percent a year.
Interest in the Consumer Price Index has grown due to debate over the federal budget and the growth in entitlements; but it is significant for other reasons. If government indexes overstate rising prices, it implies they understate growth in consumption, output, productivity and real wages -- meaning recent U.S. economic performance has been better than official statistics indicate.
Source: W. Erwin Diewert, "Comment on CPI Biases," Business Economics, April 1996.
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