Fixed-weight price indices can overstate inflation

What the study found: The study finds that measured inflation in fixed-weight price indices can differ substantially from inflation in true price indices. In the standard new Keynesian model, these differences become larger as inflation rises rapidly, especially when prices are stickier and goods are easier to substitute.

Why the authors say this matters: The authors suggest this matters because the differences can be large and persistent for inflation increases like those seen in the United States after 2020. The study indicates that this affects how inflation is measured in indexes such as the consumer price index.

What the researchers tested: The researchers constructed model-based inflation measures in time-dependent pricing models and compared inflation in true and fixed-weight price indices. They designed these measures to be analogous to inflation measures in the data, such as the consumer price index.

What worked and what didn't: The comparison showed that, in the standard new Keynesian model, the gap between the two kinds of inflation measures rises with the degree of price stickiness and the elasticity of substitution across goods. For commonly used parameter values, the differences were described as large and persistent when inflation increases were similar to those seen after 2020 in the United States.

What to keep in mind: The abstract describes model-based comparisons and does not report empirical estimates from data. It also does not provide additional limitations beyond the model setting and the parameter values discussed.

Key points

• Fixed-weight price indices can differ substantially from true price indices.
• The gap grows when inflation rises rapidly in the standard new Keynesian model.
• Greater price stickiness and a higher elasticity of substitution across goods increase the differences.
• For commonly used parameter values, the differences are large and persistent for inflation increases like those after 2020 in the United States.
• The study uses model-based inflation measures designed to be analogous to data measures such as the consumer price index.