In the past year, inflation has tacked on 4.2% to your cost of living -- or so the most popular yardstick for measuring inflation, the Consumer Price Index (CPI), will tell you.
That's a high number, of course, but if you've felt that your personal inflation burden over the past year far exceeded that figure, you're certainly not alone. Calculating inflation is a monstrous task that's bound to come up less than perfect, but the torture chamber of adjustments the CPI goes through is probably one most supreme courts would deem unconstitutional. Here are a few important CPI contortions to keep in mind.
The substitution effect
You might as well call this one the "substitution of reality" effect. As the BLS (the organization that calculates the CPI) puts it, "... consumers can and do, to some degree, insulate themselves from the impact of higher prices by adjusting their spending to favor relatively lower-priced goods or services."
In English, this basically means that you won't necessarily feel the pinch of rising prices, provided you shift your purchase to something cheaper. The classic example: If the price of beef goes up, people switch their preference to chicken, so not all the increase in the price of beef counts as inflation -- despite any adverse effects it'd have on beef hogs like McDonald's
This one's related to the substitution effect. Let's say the price of gas makes up 10% of the CPI. Now let's assume the price of gas doubles in a year. To reflect this, you'd think that gas should now make up 20% of the CPI. Wrong! The weight might stay at 10%. Why? Because if the price doubles, you'll use half as much as you did before ... or so the theory goes. For many products, like gas, this is a ludicrous assumption -- even if the price rises, you likely still have to drive the same amount as you did before (or close to it).
Hedonic price changes
TV funnyman Stephen Colbert recently scored a few laughs when he quipped, "When I first started paying $4 a gallon for gas, I didn't mind. I thought I was just getting better gas." But all joking aside, the CPI uses a calculation that isn't too different.
In what they call hedonics, the prices of certain goods the CPI uses can be manipulated to reflect changes in quality. For example, if a Dell
Certain commodities go through regular seasonal adjustments. Fruit and gasoline might spike in the summer, and heating oil might spike in the winter, for example. In order to smooth out any wild swings in the CPI, some prices get a seasonality makeover before they're worked into the CPI figures. Now, over the long term, these manipulations shouldn't have any real impact on the CPI, because eventually, the fluctuations will be accounted for in another season. However, these tweaks mean that using today's CPI might not accurately reflect today's real inflation -- which is kind of the point of such a statistic.
It's a big deal
Inflation's taking a big toll on our everyday lives. Dow Chemical
Inflation should be calculated as it is, not as it ought to be.
Further inflated Foolishness:
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