Difficulties of Calculating inflation

Inflation is calculated by measuring price changes and multiplying price changes by the weighting attached to the different goods.

However, there are many different ways of calculating inflation which can lead to different results.

Some Issues With Calculating Inflation

• The family expenditure survey is limited to only 6,000 households. However, these may be unrepresentative. Also, it is only updated once a year, but people’s spending habits change frequently. eg. if a new version of the iphone comes out, it might not be in  the FES for a while.
• People may have different inflation rates. For example, old people spend a higher % of income on fuel and public transport. Therefore if these goods increase  in price old people may be relatively worse off (especially if pensions are index linked). In recent years, we have experienced a higher rate of inflation for energy and food. People on lower incomes, tend to spend a higher % of their income on food and fuel – so effectively, they have a higher inflation rate.
• Changes in Quality of Goods. e.g. if mobile phones become more expensive, is this due to inflation or better quality goods? Official statistics bodies do attempt to take into account changes in the quality of products, but this process is quite subjective. It is hard to know the extent to which more expensive phones should count as inflation or improved quality.
• Different measures of Inflation. As well as CPI, the government also calculate different methods of inflation like RPI and RPIX. RPI includes housing costs and therefore, recently has given a higher value of inflation. See: Differences between RPI, RPIX and CPI
• Chain Weighted Index. If the price of one good goes up, it may automatically change peoples spending patterns. Therefore, they stop buying the more expensive goods. Therefore, the price that they actually pay stays the same. A Chain Weighted index takes these changes in quantity into account.
• Core Inflation. Often there may be a temporary spike in inflation because of a rise in volatile goods such as energy prices and food. Therefore, the headline CPI rate may give a misleading impression to underlying inflation. See: difference between CPI and Core CPI inflation

Example of Core Inflation and CPI inflation in the US

Source: ¹

• Blue line – CPI
• red line – Core CPI – without volatile prices.

In 2008, the US experienced a jump in headline CPI inflation, but this included a temporary increase in oil prices. In 2009, oil prices fell causing a fall in headline rate.

Attempts to Overcome the difficulties of calculating inflation

• The Billion price project is an attempt to include a much wider range of published prices across the internet. BPP index at Mit

Related

• Measures of Inflation
• How is inflation calculated?