A chain weighted inflation measure takes into account changes in both price and spending patterns. A chain weighted inflation index measures both changes in the price of goods, but also reflects changes in the quantity of goods bought.
- For example, suppose you buy two goods which are close substitutes – bananas (30p) and apples (30p)
- At this price you may buy 2*bananas and 2* apples.
- Let us assume the price of bananas increased 50% to 45p, but apples stayed the same price 30p.
- This would suggest a jump in the inflation rate. 50%/2 + 0%/2 = 25% average inflation rate
However, if the price of bananas increased, you might just shift to buying apples. Therefore, the price of goods that you actually buy have not changed.
A chain weighted inflation measure would take into account the fact you no longer buy bananas. The prices you actually pay for apples have stayed the same. Therefore, it would give an inflation rate of 0% – very different to the actual CPI rate of 25%.
CPI and COLA (Cost of Living Adjustment)
- In the US and UK, benefit payments are tied to the inflation rate. (In UK we say benefits are index linked).
- In US, benefits are linked to the CPI. This is termed a cost of living adjustment (COLA) (COLA at Social Security Online) This cost of living adjustment could use a chain weighted measure rather than current CPI.
Chain Weighted Inflation Measure Gives Lower Rate
Chain weighted inflation measures tend to give a lower inflation rate than standard inflation rates. This is because if goods go up in price, you buy less of them, therefore these more expensive goods automatically get a lower weighting. However, in the traditional measure of CPI, the weights are not changed (maybe once a year, in US weights were only updated every 10 years, now every 2 years)
In the US, the personal consumption expenditure deflator PCE is calculated using a chained Fisher index. The standard CPI is calculated using a Laspeyres style index.
Problems of Using Chain Weighted Inflation Measures
- It would mean benefits rise at a lower rate.
- Some groups of people may have greater difficulty in substituting to cheaper goods. For example, if the price of bus fares rise, mobile adults may shift to using cars, but young or old people may be stuck with paying higher bus fares.
- Some argue inflation currently underestimates living costs rather than over-estimating costs. eg. food prices excluded from core inflation measures. Using chain weighted measure could lead to fall in living costs.