Mind the Gap – Volatile Measurement Bias in the Index of Consumer Prices and Monetary Policy

I argue that the gap between consumer price index (CPI) inflation and actual inflation varies systematically across the business cycle. CPI inflation is the change in expenditure required to afford a fixed basket of varieties. Actual inflation is the change in minimum expenditure required to afford a given level of utility. In a New Keynesian model with variety entry and exit and sticky prices, the source of CPI measurement bias is statistical authority’s failure to account for new varieties in time. The model predicts that the gap between CPI inflation and actual inflation is large in absolute value whenever the economy is far from trend but small otherwise. In particular, CPI inflation overstates actual inflation in times of high productivity. Overall, CPI inflation is more persistent and less volatile when compared to actual inflation. Applying the model to U.S. CPI inflation reveals a volatile measurement bias. ∗Unter den Linden 6, D–10099 Berlin, Phone: +49 (0)3