Tuesday, July 8, 2008

Is Inflation Under of Overestimated?

Readers Comment: "Have you read the book Your money or your life? It talks about how you only incur inflation on certain things while other things actually deflate over time (technology like computers and televisions and phones, etc), so when predicting for your own personal future, inflation is overrated. I'm curious what your thoughts are on this.

It's a good question, I haven't read the book, but, I would like to mention a few points on measuring inflation. We tend to assume that the official rate of inflation must be correct, but, actually there is a lot of debate about the calculation of inflation. It is also interesting you mention that inflation is overestimated, many suggest inflation is underestimated.

Hedonics and Inflation

In the US, the BLS, used hedonics to calculate inflation. What this means is that they take into account changes in product quality.For example, the top of the range quality computer may increase in price from $700 to $750. (e.g. top of the range Apple Macs seem to get a little more expensive, but with much better features) But, because the new computer is twice as powerfu, the BLS works out that the price of computers has fallen, even though the top of the range computers may be getting a little more expensive. Maybe the same thing happens with cars; Ford bring out the latest model, which is 10% more expensive, but has '20%' better features - GPS, airbags, impact protection e.t.c. In theory, this is 10% fall in the 'price' (Note, these are just theoretical examples to explain how hedonics could be implementd)

The problem is judging the quality of a product is very much a normative opinion. The latest mobile phone may have many more features, but how many people actually use them? It is the same with computers; a new computer may be twice as fast, but, how much does it actually increase the user experience? - I would argue much less than the manufacturers would like to admit.

Therefore, you could argue that if the BLS overestimates product improvements, the inflation rate is underestimated.

On the other hand, there are many products which actually may deteriorate in value. E.g. Food may be cheaper than 50 years ago, but, more chemicals are used in the process and many argue vegetables taste more bland. It's the same with many goods which are no longer built to last. Therefore, if goods are becoming worse quality, maybe inflation is underestimated. interesting thread here Big Picture - Hedonics

The truth is that you could make arguments both ways, but, it is illustrative of how difficult it is to measure inflation exactly. BTW, I haven't completely answered your question, I will try come back to it later.

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My Vision said...

Thank you for responding. If you look at inflation on an aggregate level, overall prices are going up. However, if you look at needs on an individual basis for products you may use, perhaps cost of living stays the same or goes down. The book makes several points:
- CPI assumes the same items are bought regularly. If I buy an appliance like a stove, I probably don’t need to buy one again for several years. So while the price may go up, it doesn’t affect me.
- CPI doesn’t account for changes in buying habits. For instance, if there is a freeze on grapes in Napa, the price of wine may go up, but I may switch to drinking beer or wine from Chile. While the supply and demand determines price, it doesn’t mean I personally can’t make the switch.
- A house may go up in price in a certain area of the country. However, I may downsize my house as my kids go to college. Alternatively, I may move to another part of the country when I retire. Potentially, houses in that area could be cheaper. The energy and maintenance costs on a smaller house go down as well. Therefore, cost of living will go down as I age and my needs change.
- As prices of travel go up, people have the option of camping or taking alternative trips.
- Other things are factored into CPI, like health club membership costs, which people didn’t use thirty years ago, and an option is to walk outside (free) or do your own yardwork as a form of exercise.
- As we age, our need for certain things also decreases. For example, gas prices go up, but as we retire, we use less of it. Clothing prices may increase, but as we retire we don’t need as many clothes

Tejvan Pettinger said...

Yes, one thing worth bearing in mind is that often different people have different inflation rates. If you spend most of your money on electronic goods, your inflation rate will be lower than if you spend your money on petrol