Thursday, December 20, 2012

Another take-down by me of an important aspect of the "Fiscal Cliff"---Using the Chain-Weighted CPI as opposed to the CPI....Stay Awake!! This is important

One of the latest proposals to rein in the increasing cost of Social Security is to substitute (an appropos word as you will see in a moment) the currently used "Consumer Price Index (CPI)" with a measure called the "Chain-Weighted CPI" (go HERE for an explanation in full of this measure). First, a tiny explanation of the CPI.

The Bureau of Labor Statistics (BLS) measures changes in the price of stuff by pricing a "fixed market basket of goods and services" that are available in the economy. Consider it a shopping list on steriods.  It lists thousands of goods and/or services  that individuals might on a purchase daily, weekly, monthly, or yearly basis. 

The key point with this measure is that it prices ONLY specific, narrowly defined things on "the list" and records the change in price of the good/service with no regard to any change in consumer behavior towards the purchase of that good/service.  If the price of a pound of hamburger increases 10% the CPI will reflect that change---boom, 10% inflation (note--because one good increases in price does not indicate inflation---just keeping it simple for now).

The "Chain-Weighted CPI" is an additional measure that takes into account consumers choices in purchasing a good/service based on "relative prices" and their ability to substitute other less expensive goods/services for the one that increased in price.  If the price of hamburger increased 10% then a price sensitive consumer can subsitute a less expensive chicken or pork or spam (assume the price of these items did not increase in price at all, or something less than 10%). 

In other words, because of the presence of substitutes the consumer may not have lost as much purchasing power as the CPI suggests they did.

When measured over time, the "Chain-Weighted CPI" tends to record a lower level of inflation than does the CPI.  Why is this important?

Congress is required to adjust Social Security benefits every two years and are indexed to (tied to) the inflation rate recorded by the CPI.  If the CPI increases by 5% in the span of two years, then Congress increases Social Security checks by 5%.

However, if they switch and use the Chain-Weighted CPI, it might show that the inflation rate is only, say, 2%.  Checks would increase by only 2% rather than 5%.  A savings of 3 percentage points, which translates into BIG dollars (keep in mind, I TOTALLY made up these numbers for illustration purposes).

The move would save money but here is the biggest criticism.

Both of these market baskets measure items that senior citizens buy and young people dont buy, and vice versa. Young people buy lots of technology and entertainment that have LOTS of subsitutes.  Older people buy lots of healthcare and medicines that don't have lots of viable substitutes.  The Chain-Weighted CPI might be biased IN FAVOR of the choices available to young people in what they buy, but might be biased AGAINST older people in their purchases.

Both of these measures do not take into account the "real life" weight each demographic puts on the the selected goods/services in the measured market basket.  This specific information is not disaggregated from the whole.

This was a very simple explanation and there is MUCH more to it. For more detailed info vist the link to the Chain-Weighted CPI.  GOOD READIN'!!!!
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