Why Inflation Is Usually Overestimated

By Daniel Richards, Manzur Rashid, Peter Antonioni

Many economists think that the measures of inflation tend to overestimate the true increase in the cost of living. That is, if the inflation rate is quoted as being 3 percent, economists think that the true cost of living has actually increased by less than 3 percent.

Here are some of the reasons why:

  • The substitution effect: Inflation at 3 percent means that on average prices have increased by 3 percent. But some prices will have increased by more and some prices will have increased by less (or even decreased). In response to these changes, people alter their behavior by buying relatively more of the goods that haven’t increased in price by much and relatively less of the goods that have increased in price by a lot: hence the name the substitution effect. This means that inflation overestimates the true increase in the cost of living as people switch to relatively cheaper goods.
  • Unobservable quality improvements: As we mention in the earlier section “Adjusting for quality and size” section, inflation needs to be calculated like-for-like. Although statisticians try to adjust for quality improvements, doing so fully is impossible. Thus, some unobserved quality improvements remain unaccounted for. This means that inflation overestimates the true increase in the cost of living.

An example helps make this clear: Suppose you had $100,000 to spend from either the 2015 Amazon website or the really cheap 1963 Sears Catalog your Grannie told you about. Which would you choose? Prices were much lower in 1963, so you could buy lots more stuff, but it would be lots of low-quality stuff you would not want. So, even though the 2015 selection is much more expensive, part of that problem is compensated by the higher quality.

  • Introduction of new goods: As time passes, new goods or services are created that didn’t exist in the past. When this happens, consumers are better off because they now have a new option to spend their money on. Although these new goods may eventually be included in the “basket of goods”, the value of the new option isn’t accounted for in the inflation statistics. This means that inflation overestimates the true increase in the cost of living because it doesn’t take into account that consumers are better off due to the introduction of new goods.