What a Price Index Can and Cannot Tell Us

A price index is built by choosing a basket of goods, pricing it in one period, pricing it again later, and reporting the ratio. The arithmetic is trivial. The difficulty lies entirely in the choice of basket, and it is a difficulty that cannot be argued away, only managed. Two objections have proved particularly stubborn.

[A] The first is substitution. If the price of beef rises sharply and households respond by buying chicken, an index that continues to weight beef as heavily as before will record a larger fall in purchasing power than anyone actually experienced. [B] The second objection concerns quality. A laptop that costs what last year's laptop cost is not the same purchase if it does twice as much, and statistical agencies must decide how much of the unchanged price to treat as a hidden price cut. [C] The adjustments they use are defensible, but they are estimates, and reasonable statisticians arrive at different ones. [D] None of this makes the index useless. It does mean that a difference of a few tenths of a percentage point between two countries' inflation figures may say more about their statistical conventions than about their economies.