The Measures of Inflation

Inflation in Singapore has gone up in recent quarters, prompting understandable anxiety amongst consumers. In the answer to a parliamentary question, the minister stated that consumers could choose cheaper alternatives to minimise the impact of rising prices. I shall not wade into the big debate whether it is a good enough or adequate answer, people have perhaps already made their minds up. But just to highlight some pertinent points concerning inflation measure since I have been reading some pretty inaccurate economics.

Suppose the price of pork goes up relative to fish, the rational utility maximising consumer will switch from pork to fish consumption. This is simply the substitution effect. But the basket of goods making up the Consumer Price Index (CPI) is often kept constant, and hence do not capture this substitution effect (Laspeyres Index). This is true therefore that this measure overstates the impact of price increase on the standard of living.

In other words, holding income constant, the standard of living does not fall as much as the increase in CPI suggests. The only case where the Laspeyres Index does not overstate actual inflation is when all goods in the basket have the same percentage price increase. In that case, there is no substitution effect since relative prices remain unchanged. Political considerations aside, the parliametary answer is essentially sound. Further reading can be found here.