The purposeful fudging of Federal government statistical was by no means a new thing and had been honed to a fine art when it came to producing U.S. inflation numbers that made the people in charge look good (Please see our video on the topic: "America's Perfect Little Goldilocks Economy - Or is it? at: http://www.youtube.com/watch?v=puC4_6OV3p8). For about 25 years, 'improvements' had been added to U.S. inflation calculations that reduced the official reported level of inflation (interestingly no 'improvement' wound up increasing reported inflation). First, instead of measuring the cost of housing by comparing house prices from one period to another, owners-equivalent rent was introduced to measure housing inflation (rents usually go down on a relative basis when house prices go up). While no reputable statistician would use a substitute number for something that could easily be directly measured, government statisticians had no such qualms.
The concept of substitution effects and geometric weighting was then introduced. The idea behind a substitution effect is that when the price of some items goes up, consumers will buy less of it and more of something else. Geometric weighting means the cheaper item gets more importance in a basket of goods and the more expensive item less. This approach lowers reported inflation significantly because items go up in price at different rates and the ones that go up the fastest get less and less importance as they do. The classic example for a substitution effect is hamburger versus steak. Steak becomes expensive, eat more hamburger. So in the case of substitution and geometric weighting, if your quality of life goes down, inflation goes down as well.
The government then introduced hedonics into inflation calculations, where if your quality of your life goes up, inflation also goes down as is does with substitution. In hedonics, if you get a better product (which in an modern economy continually happens for many products), even though you pay the same price, you are considered to have paid less. For instance, if the new car you bought has more functionality than the previous car you bought several years ago, even though the actual price may have gone up, the government will say it went down because the new car is 'better' than your old car. So when hedonics is combined with substitution effects and geometric weighting, essentially no matter what prices you are paying for what combination of products, officially reported government inflation stays under control through statistical trickery. Unfortunately, the money you need to support your lifestyle is determined by the actual inflation rate and not the fantasy government figures.
Next: The Myth About the Trade Deficit and the U.S. Dollar
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