SETTING THE STAGE: WHAT ARE PRICE INDEXES?

In Chapter 1 we identified two distinct conceptual bases for the CPI that have dominated the public discussion and are the most relevant for the work of the panel: the fixed-basket approach, which was long the basis for the CPI in the United States, and the cost-of-living approach, which was strongly recommended in the Boskin report. In somewhat more detail, the two approaches are:

  • The fixed-basket approach. A basket of goods is priced in each period and the price index calculated as the cost of the basket in the comparison period divided by the cost of the basket in the reference period. Because the goods in the basket are fixed across the comparison, we call this a “cost-of-goods index” or COGI. The relevant basket for a national CPI is the set of all goods and services bought by consumers in the United States during a base period, and the prices are the market prices paid for those goods and services during the reference and comparison periods. The reference period often coincides with the base period but need not necessarily do so.

  • The cost-of-living approach, sometimes referred to as the “economic” approach. Prices in the comparison and reference period are compared using the ratio of the cost of living in the two periods. Instead of comparing the costs of two baskets of goods, the comparison is between the cost of maintaining the same standard of living in the comparison and reference periods. Exactly what is meant by the standard of living and the cost of living are matters that we discuss and, as we show in the next section, accurate evaluation of a COLI requires not only data on quantities and prices but also knowledge of how consumers respond to changes in incomes and prices. In practice, therefore, adopting the COLI as a conceptual basis does not imply using an exact COLI for the CPI but, instead, using one of a number of feasible approximations. The nature of these approximations, as well as their relationship to an exact COLI, is developed in the next section. But as is the case for basket price indexes, the calculation of the price index starts from a basket, or baskets, of goods and from lists of prices in the reference and comparison periods.

The research literature contains a number of other approaches to price indexes. One of the most important is the “test” approach associated with Irving Fisher. According to this, price indexes are judged according to a number of desirable “tests” that price indexes should ideally satisfy. For example, one test that is satisfied by all sensible price indexes is that, if all the prices going into the index are doubled, the index doubles too. Another framework is provided by the stochastic approach, in which it is assumed that there is some underlying but unobservable price level, around which the prices of individual goods and services are randomly distributed. For the purposes of this report and in the current historical situation, the COGI and COLI approaches are the obvious contenders



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