Question

In the 1990s politicians in Washington D.C. were looking for ways to balance the budget. Former Federal Reserve Chairman Alan Greenspan brought attention to the importance of the Consumer Price Index (CPI) and its link to cost-of-living adjustments (COLAs) in several areas of the federal budget--most notably Social Security. Alan Greenspan argued that the CPI overstated inflation and thus led to unjustified COLAs. According to Alan Greenspan, these unjustified COLAs therefore increased the deficit, and if the overstatements in the CPI were corrected this would contribute to balancing the budget.

The Senate Finance Committee created the Boskin Commission in the 1990s to examine possible overstatements of the CPI. The commission came out with its estimate that the CPI overstated inflation by 1.1%.

Answer the following questions:

1. If the Boskin Commission's estimate was right and the CPI overstates inflation by 1.1 % every year--what does that say about real GDP per capita and living standards in general in the United States, which are affected by the CPI ?

2. What are some of the sources of this possible overstatement of the CPI, which is calculated by the Bureau of Labor Statistics?

Answer 1

1. An overstatement or overestimation of yearly inflation by 1.1% reported by Bureau of Labor Statistics(BLS) based on the CPI(Consumer Price Index) estimation implies that the rate of increase in the general price level of goods and services every year has been overestimated or overstated and assuming that the nominal GDP and the nominal income of the individuals or households in the United States(US) as constant or unchanged, both the yearly real GDP and the standard of living in the country would be undervalued or reduced from their actual values or levels. An overestimation of the yearly inflation rate implies that considering the nominal income of the households and individuals in the country as constant, an overestimation of the yearly inflation rate would undervalue or understate the real income or their real purchasing power of the goods and services than the actual level or value. This would reduce the overall standard of living in the United States and further holding the nominal GDP level in the country as constant, the real GDP of the US would also be understated compared to its accurate value or level.

2. The CPI used by BLS basically estimates the overall or general price level of goods and services in the US, based on the consumer inflation or a fixed-weighted price index by using or observing a fixed basket of various goods and services that commonly represent the monthly consumption basket availed or purchased by the typical representative consumers in the country. However, the CPI can evidently overstate the inflation rate due to several reasons. First, substitution can be one of the common attributes to the inflation overstatement in CPI as when the price of certain goods and services increases, the consumers or households typical tend to substitute the expensive goods and service with relatively cheaper goods and services and the demand and consumption of the more expensive products and services decreases. But since the CPI only considers a fixed consumption basket or fixed-weighted price index, it cannot accurately capture such changes or adjustments in the consumer behavior or consumption pattern resulting in erroneous estimation of the inflation in the country. Secondly, technological advancement and improvement can significantly increase productivity and simultaneously reduce the cost of production of many goods and services in the economy. Therefore, such changes in the production sectors of many of the goods and services consequently lead to a price decrease of these goods and services in the consumer market thereby, increasing the real purchasing power of the consumers and households, holding everything else as constant. But CPI does not include the price of these concerned products or services in the estimation of the inflation rate until these become the common and regular items in the fixed consumption basket or the fixed-weighted price index as observed under the CPI. In this context, any new products or services launched in various consumer markets are also not included in the CPI until they subsequently become or are considered as regular items purchased by typical consumers or households. Thirdly, any changes in consumer preferences towards the wholesale stores and online retail and e-commerce portals which usually provide different and multiple varieties of products and services at a discounted price due to various sales and price offers offered by these wholesale and retail sellers, are also not captured by the CPI. Hence, the products and services purchased by consumers or households from these online wholesalers and retailers at discounted prices are not included in the fixed-weighted price index used by CPI which can also overestimate the inflation rate in the country.