Comment on Open Thread June 2010, Part 3

Sat, 19 Jun 2010 08:36:10 GMT

but what is a price index, other than an attempt at answering the question of what the "true value" of a unit of currency is? What are the fabled "real" values other than attempts at coming up with a coherent concept of "true value"?

No, no. A price index is an attempt to work out how much things cost relative to what they used to cost. Real GDP is an attempt to measure how much stuff is being produced relative to how much stuff was being produced. GDP is not an attempt to determine what that stuff is worth in a metaphysical or personal sense, the production is merely valued at its market price (adjusted for inflation, in the case of real GDP). To a pacifist, the portion of GDP spent on the military is worth less than nothing, but it's still part of GDP because it was stuff that was produced.

Or does the meaningfulness of price indexes somehow gradually fall as differences accumulate?

Yes, the closer the consumption patters of the two economies being compared, the more useful the comparison is. If there were no common goods between two economies it would be impossible to compare them meaningfully. As to where to draw the line, well I wish I had a good answer for you, but I don't. All I can say is that the value of the comparison decays over "distance" (meaning differences in consumption patterns).

Some economists have created more specialised indices for long-run comparisons; William Nordhaus created a price index for light (based on hours of work per candela-hour) from the stone age to modern times. This is a little unusual at the moment since macroeconomists don't usually do comparisons over long time periods (it's fiendishly hard to get data going back before the 20th Century on most indicators), but it shows you that we are aware of the limitations of our tools, including price indices.

In the present Western political system, whatever passes for reputable social science will be used as basis for policies of government and various powerful entities on its periphery, which can have catastrophic consequences for all of us if these ideas are too distant from reality. Macroeconomics is especially critical in this regard.

I agree wholeheartedly, good quality policy advice is something I take very seriously. The social science we have has significant limitations, but right now, we don't have anything better. I very much doubt the quality of our policy would improve if politicians paid less attention to their advisers than they do at the moment. So we do what we can, help thing along as much as our knowledge and the institutional frameworks decisions are made will permit. What else can you do?

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