Measuring Real Value and Inflation

The most important economic measures are monetary. They have many different names, are derived in different theories and employ different formulas; yet, they all attempt to do the same thing: to separate a change in nominal value into a 'real part' due to the changes in quantities and an inflation due to the changes in prices. Examples are: real national product and its components, the GNP deflator, the CPI, various measures related to consumer surplus, as well as the large number of formulas for price and quantity indexes that have been proposed. The theories that have been developed to derive these measures are largely unsatisfactory. The axiomatic theory of indexes does not make clear which economic problem a particular formula can be used to solve. The economic theories are for the most part based on unrealistic assumptions. For example, the theory of the CPI is usually developed for a single consumer with homothetic preferences and then applied to a large aggregate of diverse consumers with non-homothetic preferences. In this paper I review both the general literature and my own past contributions in order to identify theories of measurement that are based on plausible economic assumptions. It turns out that all such theories lead to the Törnqvist price or quantity indexes. The paper also covers several related topics, particularly the presently unsatisfactory determination of the components of real GDP. I also propose a novel set of integrated accounts to measure changes in relative prices as well as the sectoral sources of inflation.