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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
graphic balance can also lead to changes in aggregate spending patterns. These sorts of factors may very well contribute to long-term changes in the composition of aggregate purchases though they are unlikely to have large effects over periods of 1 or 2 years. (Below, we outline the aggregation problems that arise in constructing a national price index across individuals and households with differing economic, demographic, and other characteristics.)
A superlative index that, in effect, averages beginning and ending weights has some commonsense appeal in that it takes both states of the world into account. However, the theoretical work that demonstrates that a superlative can provide a close approximation to a measure of the change in the reference period cost of living assumes that changes in purchase patterns stem solely from substitution behavior by households with stable tastes or preferences. To the extent that changes in tastes rather than substitution behavior causes purchase patterns to shift, a superlative index will lose some of its accuracy as a measure of the cost of maintaining the reference period level of living.
In the long run, both consumer tastes and the economic and demographic distributions of households can alter substantially. Comparisons of changes over lengthy historical periods in the price level, and perhaps even more so in the cost of living, are difficult to interpret. In the short to medium run, the issue is whether changes in consumer tastes or substitution behavior tend to be the dominant explanations of changes in household purchasing patterns. As noted above, this is essentially an empirical question, one on which the historical data can shed light, though only inferentially.
Given the time lags required to produce a superlative index, the monthly real-time CPI must instead be calculated from a set number of strata indexes aggregated with fixed weights. Assuming that, due to data constraints, this will be the case for the foreseeable future, what alternatives are available to Congress for making cost-of-living adjustments to social security and other public benefits and for indexing the tax system? Should it continue with the traditional fixed-weight index, recognizing that it is likely to modestly overstate rises in the cost of maintaining the reference period’s standard of living? Should it make an initial adjustment based on the fixed-weight index (or, perhaps, on the advance estimate of a superlative index based on historical relationships between a fixed-weight and a superlative index) and then incorporate a correction into the cost-of-living adjustments that are made 2 years later, when the superlative becomes available?
In Chapter 2 the panel discusses the conceptual pros and cons of superlative indexes and other methods of accounting for substitution behavior. We also note alternative approaches to producing a lagged superlative index and techniques for making advance estimates of that index. In Chapter 7 we make recommendations about the use of a superlative index, as well as advance estimates of a superlative, in making cost-of-living adjustments (COLAs) for social security benefits and other public transfer programs.