Inflation

:This page is on the topic of price inflation in economics. For alternative meanings see inflation (disambiguation).

Measuring inflation

Inflation is measured by observing the change in the price of a large number of goods and services in an economy (usually based on data collected by government agencies, though labor unions and business magazines have also done this job). The prices of goods and services are combined to give a price index measuring an average price level, the average price of a set of products. This price is then adjusted for changes in the underlying basket of goods. The inflation rate is the percentage rate of increase in this index; while the price level might be seen as measuring the size of a balloon, inflation refers to the increase in its size.

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There is no single true measure of inflation, because the value of inflation will depend on the weight given to each good in the index, as well as the extent of the economic region being examined.

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One common dispute is whether or not qualitative improvements are understated. What does it really mean, for example, to say that the average car today costs X percent more than it used to? Does that mean there has been X percent inflation, or does most of that change represent higher prices paid for higher quality and additional features? The average car today is a much better product, and contains a lot more features, than a car in the 1950s. The cars of 1950 did not include air-conditioning, seat belts, anti-lock brakes, or many other features that have been added over the years.

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Examples of common measures of inflation include:

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• The Cost of Living Index or CLI is the theoretical increase in the cost of living of an individual, which Consumer Price Indexes are supposed to approximate. Economists argue over whether a particular CPI over or under estimates the CLI. This is referred to as "bias" within the CPI. The CLI may be adjusted for "purchasing power parity" to reflect the differences in prices for land or other local commodities which differ widely from world prices. (See Purchasing Parity Price)
• The consumer price index (CPIs) which measures the price of a selection of goods purchased by a "typical consumer". In many industrial nations, annualised percentage changes in these indexes are the most commonly reported inflation figure. These measures are often used in wage and salary negotiations, since employees wish to have (nominal) pay raises that equal or exceed the rate of increase of the CPI. Sometimes, labor contracts include cost of living escalators (or adjustments) that imply nominal pay raises automatically occur due to CPI increases, usually at a slower rate than actual inflation (and after inflation has occurred).
• The producer price index (PPIs) which measures the price received by a producer. This differs from the CPI in that price subsidation, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Many believe that this allows a rough-and-ready prediction of CPI inflation tomorrow based on PPI inflation today, although the composition of the indexes varies; one important difference is the treatment and inclusion of services.
• The wholesale price index which measures the change in price of a selection of goods at wholesale (i.e., typically prior to sales taxes). These are very similar to the PPI.
• The commodity price index which measures the change in price of a selection of commodities. In the case of the gold standard the sole commodity used was gold. While under the USA bimetallic standard the index included both gold and silver.
• The GDP deflator which is based on calculations of the gross domestic product: it is based on the ratio of the total amount of money spent on GDP (nominal GDP) to the inflation-corrected measure of GDP (constant-price or "real" GDP). (See real vs. nominal in economics.) It is the broadest measure of the price level. Deflators are also calculated for components of GDP such as personal consumption expenditure. In the United States, the Federal Reserve has shifted over to using the personal consumption deflator and other deflators for guiding its anti-inflation policies.
• The personal consumption expenditures price index (PCEPI). In its semi-annually "Monetary Policy Report to the Congress" ("Humphrey-Hawkins Report") from February 17, 2000 the FOMC said it was changing its primary measure of inflation from the CPI to the "chain-type price index for personal consumption expenditures".

Because each measure is based on both other measures, and a model that brings them together, economists often dispute whether there is "bias" either in measurement or in the model of inflation. For example In 1995, the Boskin Commission found the CPI produced by the US Department of Labor's Bureau of Labor Statistics (BLS) to be a biased measure, and gave a quantitative analysis of the bias, arguing that inflation was overstated because of people substituting away from expensive goods, and because of the "hedonic" improvements that technology created, these both reduced the rate of CPI-U increase. Another example from the early 1980's was the finding that the rental component of the CPI-U and CPI-W did not factor in the increase on rental units that were unoccupied, and that, when factored in, the rate of inflation was dramatically understated. This change was adopted in 1982 into the CPI calculations.

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Presently there are those who argue that even more hedonic adjustment should be factored in, including the tendency of people to move to less expensive areas when more expensive ones become out of reach, while others argue that the housing part of the index is dramatically understating the impact of home values on cost of living, and dramatically under accounting for the cost of medications in the cost of living for retirees.

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