Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Understanding why inflation is usually overestimated


Many economists think that 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 per cent, economists think that the true cost of living has actually increased by less than 3 per cent.

Here are some of the reasons why:

The substitution effect: Inflation at 3 per cent means that on average prices have increased by 3 per cent. 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 behaviour 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

‘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 £1,000 to spend from either the 2015

Argos catalogue or the really cheap 1973 Argos catalogue your Grannie

told you about. Which would you choose? Prices were much lower then,

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 this 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’ (see ‘Compiling a basket of products and services’ earlier in this chapter), 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.