The Consumer Price Index is a measure of the change in prices consumers pay for different goods over time. This index is often used as a benchmark for inflation. However, the inflation levels the Consumer Price Index suggests are not without controversy. Often inflation is accused of being overstated or understated. So what is the truth? And why would it be either?
No, inflation is overstatedShow moreShow less
Various biases cause inflation to be continually overstated.
Rising prices lead to people substituting certain more expensive goods with cheaper ones. For example, when the price of steak rises, households will often buy more chicken and fish instead. This means that the basket that consumers actually purchase is generally lower than a theoretical fixed basket. Economists refer to this as a substitution effect.
The Consumer Price Index in the late 1990s started incorporating the substitution effect using geometric weighting, but it still displays the tendency for inflation to lean towards being overstated.
[P1] The substitution effect means that the theoretical fixed basket used to calculate CPI overestimates how much the average household ends up spending.