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The anatomy of a price change.

In recent month, a number of articles have suggested that the Bureau of Labor Statistics Consumer Price Index CPI) may be substantially overstating the true rate of inflation. Appropriately, these commentaries focus on several critical measurements problems that must be addressed when constructing a price index such as the CPI. However, the problems, and their likely effect on the accuracy of the CPI, are presented in a way that may confuse persons concerned with how well inflation in the U.S. economy is measured. This issue of the Monthly Labor Review discusses the nature of some of the problems associated with measuring changes in consumer prices and, where possible, provides estimates of the degree to which the problems might affect the ability of the CPI to provide an accurate account of inflation.

Spending patterns. The CPI is designed to provide an estimate of what it costs today to purchase the same market basket of goods and services that consumers bought in the 1982-84 period. Thereby, the CPI gives an estimate of the additional purchasing power required today to maintain the 1982-84 standard of living. This is an important and very useful estimate; however, as critics point out, consumers' spending patterns do not remain static. Consumers alter their spending for a variety of reasons--for example, their tastes for certain goods or services may change or they may buy less expensive substitutes instead of higher priced goods and services. To this extent, the CPI does not capture changes in consumption patterns and can overstate inflation, compared with a measure that does capture the effects of such changes.

Quality changes. Just as the quantity of various goods and services that consumers buy is subject to change, so too is the quality of goods and services available to consumers subject to change. For example, each year new models of automobiles and electronic equipment are introduced with new features that make them better than the older model. To the extent that improvements in quality are counted as price changes, the CPI will overstate the true inflation rate; however, if price increases are counted as quality improvements, the CPI will understate inflation. Both scenarios affect the CPI, but the recent argument is that quality changes are predominantly missed in compiling the CPI.

New products. A similar situation occurs with new products that periodically are brought to market. New products enter the market, it is suggested, with typically high initial prices which decline as initial investment and start-up costs are recouped and changes in product supply are realized. The CPI does not immediately include new products in its sample of items for which prices are collected, and thus, the index does not reflect the potential effects of the price declines of these new items on consumer purchases. Here again, the CPI has the potential to overstate inflation.

Estimation techniques. A final criticism, of a highly technical nature, has to do with the estimation technique used in calculating the CPI Price change at the basic level for which indexes are produced is estimated using a weighted average of relative price change. This estimation formula may cause an overstatement of price change because it has the potential of giving more importance to price increases than to price decreases. The overstatement would be particularly prevalent for items for which prices oscillate. There is also concern about the procedures used to introduce new samples of goods and services into the CPI The introduction of new samples could cause a short-term upward drift in the indexes.

ALL OF THESE potential sources for overstating inflation have been, and continue to be, important areas for research and methodological improvements. The articles in this issue report on measurement improvements that mitigate the effects of these problems on the CPI and discuss current and future research that may lead to more improvements. However, the articles do not discuss in much detail the effects of the introduction of new goods and services on price index estimation. BLS researchers will focus on this topic at an upcoming meeting sponsored by the Conference on Research in Income and Wealth of the National Bureau of Economic Research.
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Title Annotation:The United States Bureau of Labor Statistics' Consumer Price Index
Publication:Monthly Labor Review
Date:Dec 1, 1993
Words:687
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