inflation is defined as a general increase in the price of
goods and services. And consequently, the fall in the
purchasing power of money. And that fall in purchasing power
can be very real. When I was a kid, right around the time of
Abraham Lincoln, a bar of chocolate cost five cents. Aside
from the fact that today's version is noticeably smaller,
that same bar today would set me back $1.25. I bought my first
new car for $2,600. I'd estimate a similar model today would cost
15 times that amount. And my first house, a modern three
bedroom, three bath, tri level suburban home, cost me $28,000,
the cost today would be 20 times that amount. Even though many
years have elapsed since I was a bright eyed youngster, the
implied rate of increase in these items is about 8% per
year. Have you ever wondered how inflation is calculated? Sure,
we all know that they take a basket of goods that a typical
person might consume, and then track the price of that basket
of goods changes over time. But what gets me is that the
increase in prices often seems to have little to do with the
headline number that the government reports. Do I just
have really weird taste in things? Or is there something
else going on? Overtime in the US anyway, there have been
several adjustments to the way that inflation is calculated.
This is important because these adjustments suggest that
inflation is being underestimated. So what are
these adjustments? And what impact have they had? Today, I'm
going to focus on the two adjustments that I think are the
most significant, hedonic adjustments and substitution
effects. hedonic adjustments are an attempt to reflect
improvements in quality. So the product you used to buy cost
twice as much today, but it's also twice as good according to
the bean counters in Washington. So in reality, there has been no
inflation at all. Well, seems a little dubious to me, but I
guess I can sort of see the logic. substitution effects,
though, are a bit more dicey. The idea here is that people buy
less expensive things instead of buying more expensive things. So
beef is up 50%, but that causes people to substitute chicken for
a proportion of their beef consumption. So the overall
inflationary effect is much less. I don't know call me a
sceptic, but it seems to me if people were okay with chicken,
they would have just consumed that in the first place. So what
is the effect of these changes to the way inflation is
calculated? On average, it has been to reduce it by about 7%
per year, relative to the way it used to be calculated 40 years
ago. So if you feel as though the official inflation numbers
understate your own cost of living increases, there's a
pretty good chance that you're right. The best way to estimate
inflation is to compare your own cost of living over time, as I
did when we spoke about the candy bar or the car. When I do
that, I reckon the actual inflation rate during my
lifetime has been about six or 7% per year. It is also worth
recognising that governments around the world are some of the
biggest debtors and therefore biggest beneficiaries of
inflation. They have a vested interest in promoting a moderate
inflationary level of around 6%. While trying to convince people
that it's somewhat lower than that. For that reason, I'd
expect inflation for the longer term to approximate that six or
7% level