Questions: Price Level Measurement and Price Indices

Question 1

The Federal Reserve announces it is raising interest rates because inflation has exceeded its 2% target. Which inflation measure is the Fed referring to?

• A. The Consumer Price Index (CPI), because it is the most widely reported measure
• B. The Producer Price Index (PPI), because it leads future consumer inflation
• C. The PCE deflator, because the Fed targets 2% PCE inflation specifically
• D. The GDP deflator, because it covers all domestic production

Answer: (C)

The Federal Reserve explicitly targets 2% inflation measured by the PCE (Personal Consumption Expenditures) deflator, not the CPI. PCE uses a chain-weighted formula, covers a broader range of expenditures (including those paid on behalf of consumers), and tends to run somewhat below CPI. This distinction matters for policy analysis: when news reports CPI above 2%, the Fed may not yet have breached its stated target if PCE remains below 2%.

Question 2

Producer Price Index (PPI) readings tend to anticipate future Consumer Price Index (CPI) changes. Why?

• A. PPI uses the same fixed basket as CPI but measures it one quarter earlier
• B. Rising input costs for producers typically get passed through to retail prices with a lag, so PPI leads CPI
• C. The Bureau of Labor Statistics publishes PPI before CPI in every reporting cycle
• D. PPI measures imported goods first, which then affect domestic consumer prices

Answer: (B)

PPI measures prices at the production stage — what manufacturers pay for inputs or receive for output before goods reach retail. When input costs rise for producers, those increases typically flow forward to consumer prices over weeks or months as businesses adjust retail pricing. This pipeline dynamic makes PPI a useful leading indicator: a sustained PPI increase today predicts CPI pressure in the near future. The timing of publication is coincidental and irrelevant to the causal relationship.

Question 3

The GDP deflator automatically adjusts its basket weights over time as the composition of the economy changes, unlike the fixed basket used by CPI.

• T. True
• F. False

Answer: True

The GDP deflator covers all domestically produced final goods and services in proportion to their current share of GDP, and these weights change as the economy evolves — more tech services, fewer manufactured goods, etc. CPI by contrast uses a Laspeyres formula with a fixed reference basket, only periodically updated. This is why CPI has a known substitution bias: when prices of some goods rise sharply, consumers switch to substitutes, but CPI's fixed basket keeps counting the now-avoided expensive good at full weight.

Question 4

The CPI and PCE deflator generally produce identical inflation readings because both measure consumer prices in the United States.

• T. True
• F. False

Answer: False

CPI and PCE regularly diverge, and PCE typically runs lower than CPI. The differences stem from: (1) formula — CPI uses a fixed basket (Laspeyres), PCE uses a chain-weighted approach that allows substitution; (2) scope — PCE includes expenditures made on behalf of consumers (like employer-sponsored health insurance) that CPI excludes; (3) weights — housing (owners' equivalent rent) has a larger weight in CPI than in PCE. These methodological differences produce meaningfully different inflation readings, which is why the Fed's 2% PCE target is not equivalent to a 2% CPI target.

Question 5

Why might elderly retirees experience higher effective inflation than the official CPI suggests, and which feature of CPI's design explains this gap?

Model answer: Elderly households spend proportionally more on medical care and housing — two categories that have inflated substantially faster than the overall CPI. CPI is designed to reflect the spending basket of a typical urban consumer, which weights these categories lower than they represent in a retiree's actual budget. Because Social Security cost-of-living adjustments are tied to CPI, retirees receive increases calibrated to average spending patterns rather than their own. A 3% CPI increase may correspond to a 4–5% cost-of-living increase for someone whose spending is dominated by healthcare.

This is a concrete example of how index design has distributional consequences. The choice of basket and weights is not neutral — it determines who gains and who loses from inflation adjustments embedded in contracts, benefit programs, and wage negotiations. A separate Experimental Price Index for the Elderly (CPI-E) has been developed to track this divergence, and it consistently shows higher inflation for the 62+ population than the standard CPI.