From Dustin Woodard,
Your Guide to Mutual Funds.
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Late 2003, Greenspan mentioned that the government could save money by switching to a Chain-Weighted CPI rather than the traditional fixed CPI. The problem is that most people don't know what a chain weighted CPI is.

Before I dig into what a chain weighted CPI is, I must first talk about the current Fixed CPI. CPI is an acronym for Consumer Price Index. It is a measurement of changes in prices of consumer goods and services. This is a terribly difficult thing to measure, so the consumer price index was created - it simply represents a basket of goods for the consumer and the prices of those goods are measured over time. There are flaws with the current measurements - well get into that later.

Chain Weighted CPI

The chain weighted CPI was created to help reduce some of the biases of the fixed CPI. In particular, the fixed CPI has these flaws:

• New product bias - the best examples is computers. The CPI basket did not include computers for quite some time despite the popularity of computers. This is a flaw because the price of a computer has fallen every year (around 15-20%). New products are produced all the time and despite their popularity and increase in the quality of our lives, it takes years for them to be included in the CPI measurement.
• Quality bias - The CPI is unable to measure the increase in the quality of the goods. Camcorders, for example, are usually priced the same each year, but the quality of the product has gone up tremendously (from black and white viewfinders to flip our LCD viewfinders). Of course, this might work in reverse from some products - Coleman camping supplies come to mind - "they don't make them like they used to."
• Discounting & Substitution - The Internet is a prime example of this. Instead of buying a video at Blockbuster they might buy it through Ebay or use a comparison price engine at half the price, but the CPI may use Blockbuster's price.

Unlike the official fixed CPI, the Chain Weighted CPI reflects changes in consumer spending patterns. This is considered a much more accurate because it takes into account weight shifting. An example of weight shifting would be that I used to own three cars, but now that I telecommute, I only need one car (so I sell the cars and spend it on more computer supplies). Technically speaking, the chain-weighted price index measures the change in prices using the average of the quantities from one year to the next. Here is a mathematical example to better help you understand the difference:

George's Basket of Goods
2002: 2 Basketball shoes, 2 Tennis shoes
2003: 3 Basketball shoes, 1 Tennis shoes

Prices
In 2002 Basketball shoes costed $55, Tennis shoes costed $40
In 2003 Basketball shoes costed $50 Tennis shoes costed $55

Fixed Weighted Approach
Using the numbers from the table on the above, the calculated change in the Fixed CPI is [(2 basketball shoes x $50)+(2 tennis shoes x $55)]/[(2 basketball shoes x $55)+(2 tennis shoes x $40)]*100 = 110.5 or 10.5% inflation.
- note we used the 2002 quantities rather than the 2003 quantities.

Chain Weighted Approach
CPI is [(3 basketball shoes x $50)+(1 tennis shoes x $55)]/[(2 basketball shoes x $55)+(2 tennis shoes x $40)]*100 = 107.9 or 7.9% inflation.

Of course, these examples are simplified and not very realistic, but it gives you an idea of how the two approaches differ. Every tenth of a percent makes a difference in many pension plans, salaries, benefits and budgets for many companies, especially for the government. With Greenspan pushing for the chain weighted CPI, I wouldn't be surprised to see more organizations switch to it.

Learn more about Economic Indicators.