Curiosity 2.3: How Do the GDP Deflator and the CPI Differ?

		relative to other things? During this period the CPI increased by over 80 percent, so relative to other things pepperoni pizzas are now cheapen

		Most people, and governments, are unequivocally of the opinion that inflation is undesirable. These measurement problems indicate that measured inflation may not be a good guide to the extent to which inflation should be considered undesirable. Recent estimates suggest that current inflation measurement overestimates cost of living increases by about a percentage point:

		0.3% because of consumer substitution;

		0.2% because of inadequate reflection of improving quality;

		0.3% because of delay in incorporating new products; and

		0.2% because of improper measurement of a shift to discount retail outlets.

		This is a politically sensitive issue it is estimated that reducing Social Security indexing by 1 percent to account for this measurement bias would save a trillion dollars over the next 12 years! Another issue is that the prices of some items can be very volatile, causing the CPI to misrepresent the level of longer-run inflation. To deal with this a measure of "core" inflation is produced that removes from the CPI the influence of the two most volatile prices, those of food and energy. In addition to these measurement problems, an examination of why inflation is undesirable suggests that, surprisingly, inflation is not nearly as severe a social ill as it is generally thought to be.

		2.6 The Costs of Inflation

		Economists do not pay much heed to the usual complaints about inflation. For most people the impact of rising prices is offset by rising wages. Those living on fixed incomes, such as welfare recipients or old-age pensioners, can (although may not) be protected through appropriate policy action. Arbitrary redistribution of wealth, such as rises in real estate values, comes about mainly if an inflation is unanticipated, in which case economists would condemn it.

		From their study of microeconomics economists know that our economic system works well because prices act as signals to induce producers to produce the things we value most at the lowest cost the right prices ensure that the economy maximizes the total welfare of its participants. This is what is meant when it is said that the price system is a very efficient way of allocating and distributing goods and services. To economists, the main cost of inflation is the resource misallocation it causes the loss of efficiency that results because inflation distorts price signals. This happens in many different ways, some examples of which follow.