There are many different uses for aggregate indexes of prices and the cost of living, most prominently:

  • as a compensation measure to calculate how much is needed to reimburse recipients of social security and other public transfer payments against changes in the cost of living and for formal or informal use in wage setting;

  • for inflation indexation in private contracts;

  • as a measure of inflation for inflation-indexed Treasury bonds;

  • as a measure with which to index the income tax system to keep it inflation neutral;

  • as an output deflator for separating changes in gross domestic product (GDP) and its components into changes in prices and changes in real output; and

  • as an inflation yardstick for the Federal Reserve and other macroeconomic policy makers.

This chapter examines the application of indexes in each of these contexts.

INDEXING PUBLIC TRANSFER PAYMENTS

The CPI is widely used within government and among private parties as a means of maintaining the purchasing power of a flow of transfer payments in the face of changes in prices, sometimes specifically identified as changes in the cost of living. In a similar vein, the CPI is used to adjust eligibility limits for certain kinds of payments, usually to the poor, that were initially set in nominal dollar terms.

One overarching conceptual issue that arises when cost-of-living adjustments are provided in public transfer payments is whether the adjustments should compensate recipients only for changes in the overall cost of living for the nation as a whole or should take account of any significant differences among particular groups and individuals in society. Even if it were possible to calculate a separate index for every individual, public policy would surely not seek to provide adjustments tailored to each. Indeed, taken literally, this approach would provide incentives for individuals not to substitute away from goods whose prices had risen the most (the government transfer payment would provide the means for an individual to maintain his or her consumption of expensive wines, for example, even if their prices skyrocketed).2 However, if the goal of public policy is to ensure recipients of various public transfer programs—e.g., the poor and the elderly— against changes in the cost of living, and if cost-of-living indexes for the affected group differ systematically or frequently from the aggregate CPI, then Congress

2  

Of course, this does not preclude the use of democratic cost-of-living indexes, which are averages of the indexes of individual consumers or households.



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