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How to measure inflation: Yahoo U

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If you notice that the price of the same basketball has increased over time, you are seeing inflation.

Inflation is a major component of macroeconomics with serious consequences. High inflation in an economy can quickly devalue the purchasing power of your dollar. But deflation (when prices fall) could signal a shrinking economy.

For politicians who therefore want to maintain a delicate balance of low but stable inflation, the question is: What is the best way to measure it?

There are two main data reports that track inflation: the Consumer Price Index (from the Bureau of Labor Statistics) and the Personal Consumer Expenditure Index (from the Bureau of Economic Analysis).

The two indices are similar, but have slightly different approaches to the way they calculate total price changes.

What prices are measured with CPI and PCE?

Both indices measure inflation in the economy by looking at the prices consumers pay for a basket of goods and services.

Everything from car parts to laundry services to cereals are included in these measures (and can be easily searched on the BEA and BLS websites).

The difference is in the way CPI and PCE weigh certain categories of goods and services.

For example, household cleaning products are part of both CPI and PCE baskets, but the weighing may be slightly different between them. So, if the prices of paper towels or Windex jump, this may have a greater effect on the total number of inflation in one measurement compared to another.

What makes the CPI formula different from PCE?

The key difference is that PCE uses an “excellent”

; index, which reflects the substitution of consumers among the items when prices change.

For example, if consumers switch from apples to oranges because apples are more expensive than oranges, PCE will adjust the weights to take this into account.

By comparison, the CPI has fixed weights that could not be immediately adapted to this substitution.

Any other differences?

Indices have different approaches to some specific categories.

For example, the PCE considers the cost of medical care as the total amount paid by the consumer and the consumer’s insurance company. By comparison, the consumer price index only considers costs to the consumer.

Airline tickets are also measured differently between the two. The PCE considers the cost of a flight based on the number of miles traveled by a passenger. However, the CPI compares prices for sample routes.

Who is better?

One is not necessarily better than the other. The differences are insignificant; CPI mapping versus PCE shows similar trends, although CPI tends to have higher readings than PCE.

The Federal Reserve prefers to use PCE because of its approach to substitutions. The central bank also likes PCE because BLS sometimes updates and revises past data to take into account new information and improved measurement techniques.

The Federal Reserve specifically addresses the “core” PCE, which is a version of the index that eliminates food and energy prices. The reason: food and energy prices are more volatile. For a central bank that is moving toward stable prices over time, dramatic but temporary indications of inflation (ie, from a storm that affects harvest prices or political opposition that affects gas prices) may mislead the Fed about what it does with politics.

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