For more than eight decades, some of the smartest people in the economics business have worked on index-number theory. The basic issue is how to measure price inflation. A few years ago the government (Bureau of Labor Statistics) started publishing measures (chain-weighted price indexes) that no longer fail to account for consumers constantly shifting the bundle of goods they buy toward those whose prices are rising less rapidly, as the standard CPI does. Consumers do substitute when relative prices change, and the new measures recognize this.
This issue is technical, but it has become crucial in the “fiscal cliff” discussion. Republicans wish to use the new measure to index (link to inflation) benefits of transfer programs, particularly Social Security (OASDI). Liberals don’t like this — it will slow growth of incomes among Social Security recipients (me included). I hate to say it, but the Republicans have it right on this one: using a chain-weighted price index better reflects the true rise in the cost of living. If we are indexing benefits, as we have now for many years, it should be done properly. And here’s a case where economic theory, coupled with careful applied research by a government agency, has produced the right answer. It’s time to use it.