Problems with the CPI
Commodity Substitution Bias
Over time, some prices rise faster than others. Consumers substitute towards goods that become cheaper.
The CPI misses this substitution because it uses a fixed basket of goods. Therefore, the CPI overstates
increases in costs of living.
Introduction of new goods increases variety, allows consumers to find products that more closely meet their
needs. Dollars become more valuable, and the CPI misses this effect because it uses a fixed basket f
goods. Thus, the CPI overstates increases in the cost of living.
Unmeasured Quality Improvements are not fully captured and this CPI overstates increases in cost of living.
Inflation in cost of living: 1.2%
Importance in Problems with the CPI
Each of the three problems causes the CPI to overstate cost of living increases (Likely around 0.5%)
CPI is used to determine inflation adjustments for: Private and public pension plans, personal income tax
deductions, some government social payments, and many private sector mage settlements.
THE GDP DEFLATOR vs. THE CPI
Economists and policymakers monitor both to see how quickly prices are rising, usually they tell a similar