Consumer price index

The Consumer Price Index, or (CPI), is a metric used by economists to determine changes in the cost of living for the average consumer. There are other indexes used to determine or measure price fluctuations, such as the Employment Cost Index, Producer Price Index, etc., however, most people are concerned with the CPI. In general, Austrians tend not to rely on the CPI both for methodological reasons and inherent problems with how the CPI is constructed or interpreted.

How to calculate the CPI
There are essentially four steps to calculate the CPI.


 * 1) Determine which items to place in the basket;
 * 2) Purchase the basket;
 * 3) Purchase the basket at some point in the future, e.g. one month, one year, etc.;
 * 4) Compare the two numbers (total prices of each basket).

Note: the basket is a collection of regularly purchased consumer items such as food, housing, clothing, and transportation related items.

Problems gauging inflation
In general, economists, politicians, and members of the news media tend to understand inflation as a price phenomenon, rather than one related to monetary policy. Because of this, great attention is given to the CPI. However, Austrians understand that the CPI is merely a statistic; and a poor one at best. . Below are some of the problems with the CPI.

One issue is that the CPI often has a substitution bias. A basket of goods is fixed with a certain quantity of items, and their prices don’t necessarily grow in step with one another; some will grow or shrink faster than others. When the price of one item outpaces its substitutes, as in the hypothetical case of wheat and rice, consumers tend to shift towards the cheaper item, all else being equal. So, if the cost of wheat grows significantly higher than rice, consumers will increase the quantity of rice they buy in lieu of wheat. However, because the quantity of wheat purchased is static in the basket, it is assumed that the grain is still purchased in the same quantity, which artificially elevates the CPI.

The introduction of new goods can also distort the CPI. This is best understood in terms of the quantity of goods relative to the quantity of currency units. When the number of goods increases, the currency can purchase more of those goods, causing its value to rise. Because the CPI’s basket is fixed, just as above, these new goods are not counted, and therefore do not reflect the true value of the currency, once again overstating inflation.

Another factor which is not accurately reflected by the CPI is unmeasured changes in quality. When the producers of a good improve its function, add features, or otherwise make it more attractive to consumers, the currency’s purchasing power increases, because more value can be exchanged per unit. When a basket of goods is fixed with models from say, the year 2000, all of the innovation between then and now is not accounted for, and the real value is thus not shown. Just as above, this would tend to overstate inflation.

Chained Consumer Price Index
"Chaining" the index means taking a slightly broader view of how the baskets should work in order to account for switching behavior. One reason people buy pork, for example, is that it’s cheaper than beef. But so is chicken. So if pork prices rise, price-sensitive shoppers will probably shift and buy less pork and more chicken. In other words, the price of pork went up, but the overall impact on meat prices is smaller than a naïve look at the movement in pork prices would suggest.

A shopper might respond to an increase in the cost of Granny Smith apples, for example, by switching to lower-cost Red Delicious. On average, this kind of behavior-linked chaining makes the chained index about 0.25 to 0.35 percentage points lower than the unchained index. So great news! Unless, that is, you really like Granny Smith apples. In the grand scheme of things, some goods are fairly substitutable, but they make the different varieties for a reason—people have preferences about this stuff. By shifting chaining assumptions far enough, inflation can be made to completely vanish. If people can’t afford medical care, they’ll just buy over-the-counter homeopathic remedies instead. The chained index doesn’t go nearly that far, but the point is that there’s no unique right or wrong answer for how to treat product shifting, and its impact on individuals’ welfare will vary enormously.

This matters a great deal for Social Security, however, because benefit levels are adjusted upward each year in line with inflation. If Congress decides that chained index is the "right" measure of inflation, benefit levels will be lower than currently predicted and the deficit will go down.

Tax brackets are pegged to inflation as well. If you switch tax brackets to chained index, then taxes will rise gradually as benefits fall. But in terms of accuracy, it should be noted that the BLS also calculates the Experimental Price Index for the Elderly (CPI-E) for reference purposes weighted to the basket of goods consumed by the elderly and finds that these prices generally rise faster than the regular index. Grandma buys a lot of health care services and isn’t so interested in the falling price of an iPad 2.