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 Chapter
The CPI and

CHAPTER OUTLINE
the Cost
of Living
1. Explain what the Consumer Price Index (CPI) is and how it is calculated.
A. Reading the CPI Numbers
7
B. Constructing the CPI
C. The CPI Market Basket
D. The Monthly Price Survey
E. Calculating the CPI
F. Measuring Inflation and Deflation
G. The Price Level, Inflation, and Deflation in the United States
2. Explain the limitations of the CPI and describe other measures of the
price level.
A. Sources of Bias in the CPI
1. New Goods Bias
2. Quality Change Bias
3. Commodity Substitution Bias
4. Outlet Substitution Bias
B. The Magnitude of the Bias
C. Two Consequences of the CPI Bias
1. Distortion of Private Contracts
2. Increases in Government Outlays and Decreases in Taxes
D. Alternative Consumer Price Indexes
1. Chained Consumer Price Index (C-CPI)
2. Personal Consumption Expenditures Price Index (PCEPI)
3. PCEPI Excluding Food and Energy
3. Adjust money values for inflation and calculate real wage rates and real
interest rates.
A. Dollars and Cents at Different Dates
B. Nominal and Real Values in Macroeconomics
C. Nominal GDP and Real GDP
D. Nominal Wage Rate and Real Wage Rate
E. Nominal Interest Rate and Real Interest Rate

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116 Part 2 . MONITORING THE MACROECONOMY

◼ What’s New in this Edition?

In addition to updated data throughout, Chapter 7 introduc-
es price level as a key term, adds the chained CPI to the cov-
erage of alternative measurements, and features a new Eye
on the US Economy exploring the sticky-price CPI.

◼ Where We Are
In Chapter 7, we explain what the Consumer Price Index
(CPI) is and how it is calculated. We examine the limitations
of the CPI as a measure of the cost of living. Next we look at
alternative measures of the price level: the chained CPI, the
PCE price index, and the PCE price index excluding food
and energy. Finally we show how to adjust money values for
inflation and calculate real wage rates and real interest rates.

◼ Where We’ve Been

The previous chapters described other basic measurements
in macroeconomics—GDP and the labor market. Chapter 5
described the basic facts about the macroeconomy, such as
how U.S. GDP has changed over time. Chapter 6 discussed
employment and unemployment and their changes over time.

◼ Where We’re Going

This chapter is essentially the last descriptive chapter. The
next chapter starts the more theoretical part of the course. It
examines the economy at full employment and discusses po-
tential GDP and the natural unemployment rate.

IN THE CLASSROOM

◼ Class Time Needed

The material in this chapter can be covered in one and a half to two class ses-
sions. If you mention current events, such as the current inflation rate, be sure to
use the most current data available. You can check the Foundations or BLS Web
site for these data.
An estimate of the time per checklist topic is:
• 7.1 The Consumer Price Index—30 to 45 minutes
• 7.2 The CPI and Other Price Level Measures—30 to 40 minutes
• 7.3 Nominal and Real Values—20 to 30 minutes

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 Chapter 7 . The CPI and the Cost of Living 117

Class Activities: Ask your students to match their expenditure patterns with those in the CPI
basket displayed below. The table presents a list of items and what the Bureau of Labor Sta-
tistics reported as the average expenditure in a typical market basket of goods for 2016. List
the categories and leave the percentages blank. Next, ask your students to write down their
own personal percentage expenditures for the list you have provided them. Remind them
that they should make estimates of what percentage each item represents in terms of their
annual income. After a couple of minutes or so, reveal the actual weights that the BLS report-
ed for 2016. Then ask your students to place a check mark against each expenditure category
in which he or she observes a substantial difference in relative weightings. In addition, you
also can ask them to reveal if there are any items that are on their personal list that did not
make it on the BLS list. The point of this activity is to demonstrate that although the CPI is a
statistically sound measure of the average change in the cost of a bundle of goods; it does not
measure each and every individual person’s average change in cost.
Indeed, there is at least one item on this list that has a markedly different weight of im-
portance than the figure that your students assigned to it. That item is education. Many stu-
dents who are working their way through college are probably also paying their own tuition.
It is likely that the percentage in this category is much higher than the BLS reported figure.
This activity can be combined with the Eye on Your Life discussed at the end of this chapter.

2016 Weight in CPI Market Basket

Item (percent)
Housing 42.1
Transportation 15.4
Food and beverages 14.8
Medical care 8.4
Education and communication 7.1
Recreation 5.8
Apparel 3.2
Other goods and services 3.2

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118 Part 2 . MONITORING THE MACROECONOMY

CHAPTER LECTURE

◼ 7.1 The Consumer Price Index

The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban con-
sumer for a fixed market basket of consumer goods and services. The CPI is calculated monthly
by the Bureau of Labor Statistics (BLS).
Reading the CPI Numbers
• The CPI is defined to equal 100 for a period called the reference base period. The cur-
rent reference base period is 1982-1984, so the average CPI during that period was 100.
• In May 2016, the CPI was 240.2. Thus, since 1982-84, prices have increased by 140.2 per-
cent to May 2016.
Constructing the CPI
• The BLS conducts a survey of consumers (the Consumer Expenditure Survey) to deter-
mine the average market basket of goods and services purchased by urban household.
Then each month the BLS records the prices of goods and services in the market basket,
keeping the representative items as similar as possible in consecutive months. The BLS
uses the fixed basket quantities and the recorded prices to determine the cost of the bas-
ket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in
the current month to the cost in the base period, or
(Cost of CPI basket at current period prices)
 100.
(Cost of the CPI basket at base period prices)
• For example, suppose the initial survey shows that the CPI market basket is 2 books and
20 coffees. The initial base period prices and quantities are in the first table below. In this
base period, say 2016, the cost of the CPI market basket is $100.
• Next suppose that the BLS survey taken one Cost
month in 2017 reveals that the price of a Item Quantity Price (dollars)
book is $35 and the price of a coffee is $3. Books 2 $30 $60
These 2017 prices and the initial base period Coffee 20 $2 $40
quantities are in the table to the right. In this Basket $100
period the cost of the CPI basket is $130.
• Using these data, the CPI equals ($130  Cost
$100)  100, or 130. So between the base peri- Item Quantity Price (dollars)
od and the current period, the CPI has risen Books 2 $35 $70
by 30 percent. Coffee 20 $3 $60
Basket $130

Lecture Launcher: Students might get the wrong idea in believing that the BLS blindly measures
exactly the same quantities of goods from year to year. While true in general, it does smooth
over some important details that are worth mentioning. One of them you could use for illus-
tration in class is the treatment of college textbooks. Below is an example:

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 Chapter 7 . The CPI and the Cost of Living 119

College textbooks have a relatively high number of replacements (which occur when the
book that has been followed is no longer sold in the outlet) and in many cases the replace-
ment is not comparable to its predecessor. For example, over the one year time period from
June 1998 to May 1999, the CPI priced a total of 948 quotes for the College textbook category.
From this full year of quotes, 113 quotes (12 percent) were replacements. Of the 113 replace-
ments, 40 quotes (35 percent) were deemed to be either comparable or able to be quality ad-
justed, and thus could be used in the CPI. The remaining 73 quotes (65 percent) were not
comparable, and were deemed to be eligible for other processing where estimated price
change is used based on price movement of comparable replacement items. Ultimately, this
meant that 1 out of every 13 priced quotes in this item category over the course of a year were
non-comparable replacements. These figures led to the conclusion that College textbooks
more than qualified as a candidate for hedonic regression analysis.1
While you probably won’t want to get into the business of what a hedonic regression analysis
is, you might still find the passage useful in demonstrating that the BLS goes to great pains to
try to get the CPI right.
1Reese, Mike, “Hedonic Quality Adjustment Methods for College Textbook in the U.S. CPI.”

Measuring Inflation and Deflation

• The price level is an average of the level of prices during a given time period.
• The inflation rate is the percentage change in the price level from one year to the next. In
 CPI in current year - CPI in previous year 
a formula: Inflation rate =    100.

 CPI in previous year 
• Deflation is when the price level is falling and the inflation rate is negative.

❑ Land Mine: Be careful to explain the difference between calculating the CPI and calculating
the inflation rate. Students easily confuse the two!

The Price Level, Inflation, and Deflation in the United States

• With the exception of 2009, the price level has increased every year since the 1970s,
though at faster rates in the 1970s to early 1980s and slower rates since the early 80s.

◼ 7.2 The CPI and Other Price Level Measures

The CPI is a cost of living index, which is a measure of the change in the amount of money that
people need to spend to achieve a given standard of living. However, the CPI is not a perfect
measure of the cost of living because it does not try to measure all the changes in the cost of liv-
ing and the components that are measured are not always measured accurately.
Sources of Bias in the CPI
• The CPI has four biases that lead it to overstate the inflation rate. The biases are:
• New Goods Bias: New goods are often more expensive than the goods they replace.

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120 Part 2 . MONITORING THE MACROECONOMY

• Quality Change Bias: Sometimes price increases reflect quality improvements (safer
cars, improved health care) and should not be counted as part of inflation.
• Commodity Substitution Bias: Consumers substitute away from goods and services
with large relative price increases.
• Outlet Substitution Bias: When prices rise, people use discount stores more frequently
and convenience stores less frequently.
The Magnitude and Consequences of the Bias
• The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about
1.1 percentage points a year.
• Many contracts and payments are indexed to the CPI. If the CPI is biased, then these con-
tracts are distorted because they incorrectly account for inflation.
• Many government outlays, such as Social Security payments, are linked to the CPI. If the
CPI is biased upward, then government outlays increase more than what is required to
offset inflation. Taxes are also indexed to the CPI so that the incomes for which tax rates
rise are adjusted to take account of inflation. The upward bias means that adjustments
are biased upward so that the government collects less tax revenues.
• To reduce the bias, the BLS has decided to undertake consumer spending surveys more
frequently.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent
amounts to close to a trillion dollars in additional expenditures over a decade. Politically, it is
hard to adjust Social Security payments for the bias, so the current plan is to reduce the meas-
urement bias in the CPI, for instance by revising the basket more frequently to reflect new goods
and substitution changes.

Alternative Consumer Price Indexes

• The Chained Consumer Price Index (C-CPI) is a measure of the price level calculated
using current month and previous month prices and expenditures. The C-CPI avoids the
bias of the CPI since it uses current period expenditures that are updated every month,
but it gets revised several times as the data on recent expenditures get revised
• The Personal Consumption Expenditure Price Index (PCEPI) is an average of the cur-
rent prices of the goods and services in the consumption expenditure part of GDP ex-
pressed as a percentage of base-year prices. The PCEPI avoids the sources of bias in the
CPI because it uses current quantities.
• The percentage change in the PCEPI excluding food and energy measures the core infla-
tion rate. Food and energy prices fluctuate much more than other prices and their
changes can obscure the underlying trends in prices.

Students (and the media) often don’t understand why core inflation is a useful measure-
ment and assume it is a way for the government or economists to trick people into think-
ing inflation is not as high by removing food and energy prices, which obviously do play
a role in people’s expenditures. It is important to identify that food and energy prices can
be extremely volatile, especially as a function of weather and global politics. Not only

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 Chapter 7 . The CPI and the Cost of Living 121

does this volatility complicate the analysis of other price changes, but from a policy per-
spective core inflation measurements may serve as a better guide than overall inflation.
Food and energy price changes that are the result of changes in weather and global poli-
tics are largely outside of the influence of policies. Therefore, it may make sense to ignore
them and focus on core inflation when designing policies, since it’s that underlying infla-
tion that may be a reflection of the functioning of the economy and economic policies, as
opposed to external factors which cannot be controlled. This is why policymakers (espe-
cially the Federal Reserve) may focus more on core inflation when designing policies.
• Over time, all of the indices move up and down in similar ways, but the previously dis-
cussed biases cause the CPI to rise slightly more rapidly than the C-CPI and PCEPI (and
PCEPI excluding food and energy rises slightly less rapidly).

◼ 7.3 Nominal and Real Values

Dollars and Cents at Different Dates
• To compare dollar amounts at different dates, we need to know the CPI at those dates. To
convert the price of a good in past dollars to its price in current dollars, multiply the ear-
CPI in present year
lier price by .
CPI in earlier year

Nominal and Real Values in Macroeconomics

The difference between nominal and real variables is important in macroeconomics. In macroe-
conomics, we generally use the GDP deflator rather than the CPI as our measure of the price level
because we are dealing with economy totals, of which consumer spending is just one part.

Real values seem to cause students confusion. Reiterate why we calculate real values and that the
calculation of the real wage is just like the calculation of real GDP, only using a different set of
variables. It may be helpful to show the real calculations side-by-side by writing out (real wage) =
(nominal wage)  (CPI) and real GDP = (nominal GDP)  (GDP deflator). In other words, show
your students the same general formula—real variable equals nominal variable divided by the
price level—applies to all real variables except, of course, the real interest rate.

Nominal GDP and Real GDP

• The GDP price index is an average of the current prices of all the goods and services in-
cluded in GDP expressed as a percentage of the base year prices.
Nominal GDP
• Real GDP =  100.
GDP price index

Nominal Wage Rate and Real Wage Rate

• The nominal wage rate is the average hourly wage rate measured in current dollars and
the real wage rate is the average hourly wage rate measured in dollars of a given refer-
ence base year.
Nominal wage rate
• The real wage rate =  100.
CPI

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122 Part 2 . MONITORING THE MACROECONOMY

• The real wage rate is the quantity of goods and services that an hour’s work can buy.
• Between 1980 and 2015 the nominal wage rate approximately tripled but the real
wage rate stayed roughly constant because the increase in the nominal wage rate just
kept up with inflation.

Ask students to think about whether it is the real wage or the nominal wage that matters to them.
You may want to use a numerical example to illustrate how an increase in prices without an in-
crease in the nominal wage will reduce the amount of goods and services a student can buy. This
procedure will help to cement the idea of the real wage.

Nominal Interest Rate and Real Interest Rate

• The nominal interest rate is the percentage return on a loan calculated by using dollars.
The real interest rate is the percentage return on a loan calculated by using purchasing
power; it’s the nominal interest rate adjusted for the effects of inflation.
• Real interest rate = Nominal interest rate − Inflation rate.
• When the inflation rate was high, during the 1970s and early 1980s, the gap between
the real interest rate and the nominal interest rate was large. The real interest rate
was negative in the mid-to-late 1970s and very high in the early 1980s, but has shown
no consistent upward or downward trend since 1976.

To be sure that your students understand that the real interest rate is similar to the real wage rate
and real GDP insofar as it’s in real terms, mention that the calculation of the real interest rate also
“deflates” the nominal interest rate. However, because the numbers are already percentages, we
must subtract the percentage change in prices (the inflation rate) rather than divide by the price
level.

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 Chapter 7 . The CPI and the Cost of Living 123

USING EYE ON THE PAST

◼ 700 Years of Inflation and Deflation

Richard Gosselin once had a historian friend ask if he could provide him with
inflation data for the past 200 years. Richard asked his friend why he wanted it
and he explained that it was for a book he was writing and he wanted to include
comparisons of the cost of living of the colonial period to that of today. Richard
told him that he would see what he could do. After speaking with someone at
the Federal Reserve Bank in Dallas, Richard had the answer. When he handed his
colleague the figures, he explained to him that the numbers might not be very
useful for comparing costs of living between such disparate time periods such as
the colonial period and today. When he asked why, Richard responded by say-
ing that it is difficult to measure changes in the cost of living between two time
periods that in all likelihood do not even share 10 percent of the same goods in
what would be a typical market basket of an average household. Richard
thought he got the point until he noticed that he included the figures in his book
anyway and gave him credit in the acknowledgement! No good deed goes un-
punished. The point of this little story is that we have to be very careful with in-
flation data that is measured over long periods of time. It’s not that the people
who computed the figures or gathered the data made a mistake. The problem is
making standard comparisons of market baskets of goods where no meaningful
comparison can be made.

◼ The Nominal and Real Wage Rates of Presidents of the

United States
As the section suggests, it is not always such a straightforward exercise to calcu-
late real wage rates. Jobs change in terms of responsibility and the amount of
physical and mental effort that must go into them. As a take-home exercise, you
can ask your students to come up with a list of five professions whose responsi-
bilities have not changed very much and five that have undergone marked
change. Then ask them to research the salary of these professions going back 50
years and calculate the real wages at decade intervals. Invite them to share the
results with the rest of their classmates at the next regularly scheduled class
meeting. This assignment can provide for a lively discussion as some students
will no doubt point to job characteristic differences that their classmates had not
thought about. It leads to the even thornier issue of coming up with valuations of
increased amenities on the job.

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124 Part 2 . MONITORING THE MACROECONOMY

USING EYE ON THE U.S. ECONOMY

◼ Measuring and Forecasting Inflation: The Sticky-Price CPI

This Eye can be useful to have students explore an important question: is it more
important to be able to measure inflation accurately or quickly? Obviously, ideal-
ly we would be able to measure it both accurately and quickly, but this section
certainly highlights that it’s not as easy as sticking a thermometer into the econ-
omy to see how it’s feeling today. Given the applications of inflation data, it may
be that for some applications highly accurate but a longer delay may be best,
while other applications a short delay but mildly inaccurate may actually be
more desirable. For example, for making policy decisions, it could be argued
that perhaps having a shorter lag may be more desirable than a higher degree of
accuracy. However, when it comes to contracts and government programs that
have cost-of-living adjustments, it may be more important to have a higher de-
gree of accuracy, even if there is a longer lag required. This may also be the case
when it comes to evaluating the effect of past policies.

◼ Deflating the GDP Balloon

This segment might be best used if you introduce it before you actually present
the discussion about the GDP price index. The GDP price index is one of these
topics for which the underlying economic forces at work is often difficult to ex-
plain. The balloon metaphor is an excellent way to appeal to students’ intuitions,
especially for visual learners. I can also be helpful to give students nominal GDP
data to help reinforce the need for deflating the GDP balloon. For example, nom-
inal GDP was roughly $3 trillion in 1980 and $18 trillion in 2016 – a six-fold in-
crease, but not a comparison that allows for useful insights without determining
how much of that increase was the result of rising prices versus increased pro-
duction. After deflating the nominal GDP balloon, we can determine that while
nominal GDP may be nearly 6 times greater, real GDP is only approximately 2.5
times greater

USING EYE ON BOX OFFICE HITS

◼ Which Movie Really Was the Biggest Box Office Hit?

This Eye discusses how a price index can be used to compare the real value of
money between time periods. If your students are anything like me, they have
heard countless times the reminiscing of elderly relatives about how things were
so much better when they were kids. You will, no doubt, have an ample supply
of students who will tell you that their elders brag about the nickel Coca-Cola

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 Chapter 7 . The CPI and the Cost of Living 125

they enjoyed or the 50-cent movies they went to. Advise your students that when
people often complain about the rising price of something they are nearly always
speaking of nominal prices, not real prices. So, in today’s dollars, how much was
that famous nickel Coca-Cola we’ve heard so much about? If we use 1939 as the
starting year, a $.05 Coca-Cola would be the equivalent of paying $.87 in 2016 –
which for a 12oz can purchased from a grocery store, would be a bit on the high
side (especially if considering the per unit price of purchasing in bulk). What
about a $.50 movie? A $.50 cent movie in 1939 (the year Gone with the Wind was
first released), would be $8.66 in 2016 – which is exactly the same as the estimat-
ed 2016 average ticket price. You might want to stress the opportunity cost ele-
ment here. That is, if the price of a particular good is rising at a slower rate than
other the prices of other goods, then the opportunity cost of acquiring that item
has actually fallen. Perhaps the good ‘ole days weren’t as good as we’ve heard!

USING EYE ON YOUR LIFE

◼ A Student’s CPI
This Eye discusses how the CPI is not necessarily a reflection of how all consum-
ers experience inflation. You can integrate the class activity previously suggested
with this Eye. How does their personal market basket compare to that of the av-
erage American household? How does it compare to the student’s basket of
goods created in this Eye? How might the market basket of a group near the op-
posite end of the age scale – senior citizens – compare to the student market bas-
ket and the average market basket used by the CPI? Given that college students
and seniors may rely on more fixed incomes than most groups (financial aid and
Social Security, respectively), why do these price trends pose more of a problem
for these groups? Why might using CPI measurements for different groups (a
student CPI, a senior CPI, etc) instead of just the general CPI be useful for target-
ed income assistance programs like financial aid and Social Security? How does
the fact that the CPI tends to overstate the actual rate of inflation complicate this
analysis?

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126 Part 2 . MONITORING THE MACROECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT

◼ Questions
◼ Checkpoint 7.1 The Consumer Price Index
1 A Consumer Expenditure Survey in the city of Firestorm shows that people
consume only firecrackers and bandages. In 2010, the year of the survey
and also the reference base year, the average household spent $100 on fire-
crackers and $10 on bandages. The price of a firecracker in 2000 was $2, and
the price of bandages was $1 a pack. In the current year, 2011, the price of a
firecracker is $3 and the price of bandages is $1.25 a pack. Calculate:
1a. The CPI basket.
1b. The percentage of a household's budget spent on firecrackers in the base
year.
1c. The CPI in 2011.
1d. The inflation rate in 2011.
2. Assume a two-good world in which the market basket is 10 units of good A
and 2 units of good B. Good A costs $4 and good B costs $1 in year 1. Fur-
thermore, assume that in year 2 the prices rise to $5 and $2, respectively.
Calculate the inflation rate in year 2. Will the choice of base year affect your
answer?
◼ Checkpoint 7.2 The CPI and Other Price Level Measures
3. In Virtual Reality, time travel became 3001 3002
possible only in 3002. Economists in the
Item Quantity Price Quantity Price
Statistics Bureau decided to conduct a
Games 10 $30 5 $35
Consumer Expenditure Survey in both
Time 0 − 10 $4,000
3001 and 3002 to check the substitution Travel
bias of the CPI. The table shows the re-
sults of the survey. It shows the items
that consumers buy and their prices. The Statistics Bureau fixes the refer-
ence base year as 3001 and asks you to:
3a. Calculate the CPI in 3002 using the 3001 CPI basket.
3b. Calculate the CPI in 3002 using the 3002 CPI basket. I
3c. Explain whether there is any substitution bias in the CPI that uses the 3001
basket.
4. List the sources of bias in the CPI that are discussed in the text and give a
brief explanation of each.
5. Identify the consequences of the CPI bias mentioned in the text and discuss
each.

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 Chapter 7 . The CPI and the Cost of Living 127

◼ Answers
◼ Checkpoint 7.1 The Consumer Price Index
1a. The CPI basket is the quantities bought during the Expenditure Survey
year, 2010. Households spend $100 on firecrackers at $2 a firecracker so the
quantity of firecrackers bought was 50. Households spend $10 on bandages
at $1 a pack so the quantity of bandages bought was 10 packs. The CPI bas-
ket is 50 firecrackers and 10 packs of bandages.
1b. In the reference base year, expenditure on firecrackers was $100 and ex-
penditure on bandages was $10, so the household budget was $110. Ex-
penditure on firecrackers was 90.9 percent of the household budget: ($100 
$110)  100 = 90.9 percent.
1c. To calculate the CPI in 2011, find the cost of the CPI basket in 2011 and
2010. In 2010, the CPI basket costs $110 ($100 for firecrackers and $10 for
bandages). In 2011, the CPI basket costs $150 for firecrackers (50  $3 a fire-
cracker) plus $12.50 (10 packs of bandages  $1.25 a pack), which is $162.50.
The CPI in 2011 equals ($162.50  $110)  100 = 147.7.
1d. The inflation rate in 2011 is [(147.7 − 100.0)  100.0]  100 = 47.7 percent.
2. The cost of the basket in year 2 is $50 + $4 = $54. The cost of the basket in
year 1, the base year is $40 + $2 = $42. The CPI for year 2 is $54  $42  100 =
128.5. The inflation rate in year 2 is [(128.5 − 100.0) ÷ 100.0]  100.0 = 28.5
percent. It doesn’t make any difference which year is chosen as the base
year. We get the same rate of inflation for year 2.
◼ Checkpoint 7.2 The CPI and Other Price Level Measures
3a. Using the 3001 CPI basket, the cost of the basket in 3001 is $300 and the cost
of the basket in 3002 is $350. (Note that time travel does not enter into the
cost in 3002 because it is not in the CPI basket.) The CPI in 3002 is ($350
÷$300)  100 = 116.7.
3b. Using the 3002 CPI basket, the cost of the basket in 3001 is $150. (Note that
time travel does not affect the cost of this basket because its price is unde-
fined in 3001.) The cost of 3002 CPI basket in 3002 is $40,175. (10 time trav-
els  $4,000 + 5 games  $35). The CPI in 3002 is ($40,175 ÷ $150)  100 =
26,783.3.
3c. There is not any commodity substitution bias but there is a huge new goods
bias. In particular, the new good, time travel, is significantly more expen-
sive than the good it is partially replacing, games. Some of the price in-
crease caused by the introduction of time travel is not pure inflation but in-
stead represents the higher quality of time travel as entertainment com-
pared to games.

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128 Part 2 . MONITORING THE MACROECONOMY

4. There are four biases:

New goods bias — new goods replace old goods all the time. The problem
rests in how to measure changes in the prices of goods when the goods
themselves might no longer be directly comparable.
Quality change bias — difficult to account for changes in the quality of a
good across time. If a good is really better and costs more does it make
sense to conclude that all the increase is attributable to inflation? Filtering
out the two is not an easy job.
Commodity substitution bias — because the CPI is based on a fixed basket, it
does not take into account that consumers can and will make substitutions
away from goods whose prices rise and toward relatively cheaper substi-
tutes. If a consumer reduces his or her consumption of a particular good
whose price has risen, his or her total expenditure on that item may not be
any greater than before.
Outlet substitution bias — the fact that consumers substitute from shopping
at full service retail stores to discount stores when prices rise. This substitu-
tion is not taken into account when computing the CPI, which places an
upward bias in the CPI measurement.
5. One consequence of the CPI bias is that it distorts contracts. Many private
contracts use the CPI as a cost of living adjustment measure. If the figure is
biased upward by one percentage point, the bias will lead employers to pay
more for labor than the increase in the true CPI would suggest. A second
consequence is increases in government outlays. Several federal govern-
ment outlays tie benefits to the CPI. These include Social Security recipi-
ents, food stamps, and pensions paid to former military personnel and civil
servants. Over many decades these outlays can add up to a trillion dollars.
The third consequence is decreases in tax revenues. For some taxes, the lev-
els of income at which higher tax rates are applied are linked to the CPI. Be-
cause the CPI is upward biased, these income levels rise more rapidly than
does the cost of living and so the amount of tax revenue collected by the
government is lower than would otherwise be the case.

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