Mervyn King: The inflation target ten years on
Speech by Mr Mervyn King, Deputy Governor of the Bank of England, delivered to the London School
of Economics, London, 19 November 2002.
The references for the speech can be found on the website of the Bank of England.
* * *
1. Introduction
Ten years ago, in this very room, Robin Leigh Pemberton (then Governor, now Lord Kingsdown),
delivered the first LSE-Bank of England Lecture. It was entitled "The Case for Price Stability". In the
twenty-five years prior to that lecture, prices had risen by over 750%, more than over the previous two
hundred and fifty years. So the audience on that evening in November 1992 had grown up in a world
in which rapidly rising prices appeared inevitable. They were the inflation generation. To them price
stability seemed remote. Inflation was simply taken for granted.
But that LSE-Bank of England Lecture coincided with the introduction of a new monetary framework -
the inflation target. Since then price stability has become a reality. Over the past decade inflation has
averaged 2.5%, and has been no lower than 1.5% and no higher than 3.3%
Alan Greenspan defined price stability as when "expected changes in the average price level are small
enough and gradual enough that they do not materially enter business and household decisions." With
inflation expected to remain close to 2.5%, it is no longer a material concern to families and
businesses in this country. Alan Blinder, who was Alan Greenspan's deputy at the Federal Reserve
Board, put it even more clearly. Price stability, he said, was when ordinary people stop talking and
worrying about inflation. And so successful has been the pursuit of low inflation that some
commentators have talked about the "death of inflation" and others have become increasingly
concerned about the prospect of deflation.
Tonight I want to re-examine the case for price stability, and ask the following questions. Did the
benefits of low inflation promised ten years ago materialise? Is the case for price stability the same as
in 1992? What does price stability mean in practice? Finally, what are the challenges for monetary
policy over the next decade?
2. Ten years of the inflation target: what has it achieved?
Since Britain's departure from the Exchange Rate Mechanism in September 1992, monetary policy
has been based on an explicit numerical target for the rate of inflation - now 2.5% - and a high degree
of transparency and accountability. Indeed, it was in his LSE lecture that Lord Kingsdown announced
that the first Inflation Report would appear in February 1993. And last week's Report completes
exactly a decade of Inflation Reports - forty assessments of the outlook for growth and inflation in the
British economy.
Although inflation targeting in the United Kingdom is now ten years old, the most significant
institutional changes occurred five years ago. Decisions on interest rates were taken out of the political
arena in May 1997 and delegated by the Chancellor to the new Monetary Policy Committee. It is too
soon to compare the nine-member Monetary Policy Committee with the Council of Nine that ruled
Siena during the fourteenth century. Exactly 660 years before the Chancellor created the MPC, the
Council of Nine commissioned Lorenzetti to paint the marvellous frescoes in the Palazzo Pubblico
showing the virtues of Good Government and the vices of Bad Government. There are few more
convincing representations of the case for stability than those frescoes. Since the MPC has not, at
least yet, discovered a modern Lorenzetti, I shall present the case for price stability in a more
orthodox, if less compelling, visual form.
Chart 1 shows consumer price inflation in this country over the past fifty years. The decade of inflation
targeting stands out as a period of low and stable inflation. Table 1 shows that not only has inflation
been lower since inflation targeting was introduced, but that, as measured by its standard deviation, it
has also been more stable than in recent decades. Moreover, inflation has been less persistent - in the
sense that shocks to inflation die away more quickly - under inflation targeting than for most of the past
century.1
Now this fall in inflation has led to sharp reductions in nominal interest rates, at both short and long
time horizons, as shown in Table 2. That reflects both lower inflation expectations and smaller risk
premia to compensate for future inflation uncertainty. The total inflation premium - the sum of expected
inflation and the inflation risk premium - is measured by the difference between yields on conventional
and index-linked government securities. Chart 2 shows that the total inflation premium fell significantly
on the announcement of Bank of England independence and the creation of the MPC. It is highly
suggestive of a fall not just in expected inflation but also in the inflation risk premium. In principle, the
behaviour of businesses and households depends on real interest rates - nominal interest rates less
the expected increase in prices.2 To the extent that the inflation risk premium falls, then so too does
the level of real interest rates. The evidence in Chart 2 suggests that real rates have fallen too,
although by less than nominal rates.
Chart 1
Annual inflation in the UK
Note: Four-quarter growth rate of the quarterly retail price index (RPI) until 1974,
and four-quarter growth rate of the quarterly retail price index excluding mortgage
interest payments (RPIX) after 1974. Note that the RPI methodology before 1974
did not include mortgage interest payments, so the RPI series before 1974 is
equivalent to RPIX in that sense. Data up to 2002 Q3.
Source: ONS.
Table 1
Inflation in the UK
Mean St. dev
1950-1959 4.14 1.06
1960-1969 3.65 0.72
1970-1979 13.07 1.81
1980-1992 6.40 1.14
1993-2002 2.49 0.24
1950-2002 5.93 1.41
Note: Mean inflation is the total increase in the quarterly price level (RPI until 1974, RPIX after 1974) over the period
indicated, expressed as a four-quarter growth rate. Standard deviation is calculated on quarterly inflation rates (not
annualised) over the period indicated. Data up to 2002 Q3.
Source: Bank of England calculations based on ONS data.
Table 2
Short and long interest rates in the UK
Short rate Long rate
Mean St. dev Mean St. dev
1950-1959 2.87 1.67 4.40 0.88
1960-1969 5.51 1.31 6.58 1.07
1970-1979 8.92 2.81 11.94 2.41
1980-1992 11.28 2.23 10.83 1.88
1993-2002 5.58 0.88 6.38 1.59
1950-2002 7.09 3.59 8.19 3.32
Note: Short rates are three-month treasury bill yields. Long rates are 20-year gilt yields. Data are monthly, and use the rate at
the close of the last business day of the month. Data up to September 2002.
Source: Global Financial Data, Inc.; Bank of England calculations.
BIS Review 68/2002 3
Chart 2
Total inflation premium expected
in ten years time, UK 1997
Note: The total inflation premium is measured as the difference between implied forward
nominal rates on conventional gilts ten years hence and implied real rates on index-linked
gilts ten years hence.
Source: Bank of England.
So price stability appears to have led to a more stable macro economic environment, with fewer
surprises to inflation, less inflation uncertainty, and a lower level of real interest rates. Has this
improved nominal performance led to greater stability of the real economy? Table 3 shows that since
1992, output has grown at a little above its forty year average, and has been much more stable than
before. The standard deviation of quarterly growth rates over the past decade was less than half that
in earlier periods.
Can these gains in terms of greater stability be attributed to a more stable monetary regime? After all,
a sceptic might argue that the causation runs from a more stable economic environment to lower
inflation. But some of these alternative explanations, such as the rise in the share of services in total
output and better inventory management, are part of longer-term trends and do not fit well with the
observation that volatility has fallen sharply over the past decade. And shocks to the UK from the
world economy and from the sterling real exchange rate have been as large, if not larger, over the past
five years as in earlier periods.3
Table 3
Real GDP growth in the UK
Mean St. dev
1956-1959 2.42 1.22
1960-1969 3.15 0.92
1970-1979 2.12 1.42
1980-1992 1.86 0.84
1993-2002 2.76 0.36
1956-2002 2.42 0.98
Note: Mean GDP growth is the total increase in real quarterly GDP over the period indicated, expressed as a four-quarter
growth rate. Standard deviation is calculated on quarterly growth rates (not annualised) over the period indicated. Data up to
2002 Q2.
Source: Bank of England calculations based on ONS data.
It is, of course, difficult to identify the effect of changes in the monetary policy regime on the path of
total output. One approach is to consider long runs of data which make it easier to identify structural
breaks in the behaviour of output. Luca Benati of the Bank of England has been investigating the
statistical properties of inflation over long periods for a number of countries. He finds that changes in
the behaviour of inflation appear broadly to coincide with changes in the monetary policy regime.
Some tentative evidence that this general conclusion applies to the UK can be found in the behaviour
of ten-year forward interest rates on UK government bonds. At this horizon, high and variable interest
rates are signs of high expected inflation and a large inflation risk premium. As shown in Chart 3, the
ten-year forward interest rate has fallen significantly in recent years, and has been less variable since
inflation targeting, and especially the MPC, were introduced.
What is the mechanism by which monetary policy contributes to a more stable economy? I would
argue that monetary policy is now more systematic and predictable than before. Inflation expectations
are anchored to the 2.5% target. Businesses and families expect that monetary policy will react to
offset shocks that are likely to drive inflation away from target. In the jargon of economists, the "policy
reaction function" of the Bank of England is more stable and predictable than was the case before
inflation targeting, and easier to understand.4 More simply, monetary policy is not adding to the
volatility of the economy in a way that it did in earlier decades.
Ten year forward rates in the UK 1970-2002
Note: Implied forward nominal rates on conventional gilts ten years hence, calculated on the
last business day of the month.
Source: Bank of England.
3. The case for price stability: what have we learnt over the past 10 years?
The costs of departing from price stability - either inflation or deflation - depend upon whether it is
expected or comes as a surprise. In his 1992 lecture, Lord Kingsdown distinguished three costs of
unanticipated inflation and four of anticipated inflation. I shall focus on the former, commenting on the
latter only briefly. Although none of the ideas are new, research since 1992 has thrown new light on
both the theoretical and the empirical relevance of the costs of inflation. The main costs of
unanticipated inflation are:
(i) Distortions to production and investment resulting from mistakes in distinguishing
between relative and absolute price changes
The crucial link between price stability and production and investment is that high inflation is
associated with more volatile and uncertain inflation. I showed earlier that as inflation has fallen in
Britain, so too has its variability. The same link can be seen in cross-section data. Chart 4 shows the
relationship between average inflation and its variability, measured by its coefficient of variation, over
different time horizons for a sample of 144 countries. In all cases it is clear that inflation uncertainty
increases with the average inflation rate.
But does this link between inflation and its volatility mean that higher inflation results in greater
variability of relative prices? Chart 5 provides the answer for the UK. For each (approximate) decade
for which the data on 80 sub-components of the retail prices index are available, the chart shows the
relationship between the standard deviation of those relative prices and the inflation rate in each
month. At low inflation rates, say up to 4% a year, it appears that it is the absolute value of changes in
relative prices that is linked to the inflation rate. This would be the case, as in Britain recently, where
changes in relative prices, whether up or down, were largely responsible for short-term fluctuations in
the inflation rate around a relatively stable long run level. Variability in relative prices might lead
inflation to be either above or below the inflation target, but not systematically in one direction or the
other. Increases in house prices move the inflation rate up and falls in oil prices move it down. In both
cases, an increase in the variability of relative prices leads to movements of inflation away from the
target, but not in a systematic direction. But at higher rates of inflation (or deflation) the deviation of
inflation from zero is positively correlated with the variability of relative prices. Hence, outside a range
close to price stability, the higher the inflation rate, the greater is the variability of relative prices.
Cross-country relationship between level and variability of inflation
Note: Mean inflation is the total increase in the quarterly consumer price index, expressed as a four-quarter growth rate, over
the indicated horizon ending in 1999 Q4. The variability of inflation is the coefficient of variation (standard deviation divided by
the mean) of the gross inflation rate (ie 1 + growth rate) over the indicated horizon ending in 1999 Q4. Each panel covers the
all the countries for which a consumer price index was available over the indicated horizon. The largest sample size is 144
(for the 5-year horizon), the smallest sample is 85 (for the 25-year horizon).
Source: IMF International Financial Statistics, data item 64, and Bank of England calculations.
BIS Review 68/2002 7
Inflation and relative price variability in the UK
Note: Inflation is the total increase in monthly RPIX over the period indicated, expressed as a 12-month growth rate. Relative
price variability is the cross-sectional standard deviation of the monthly increases of 80 sub-components of the RPIX in each
month. Data ends August 2002.
Source: Bank of England calculations based on ONS data.
So inflation makes it more difficult for firms and households to work out whether the prices of the
products they buy and sell have changed relative to other goods, or whether there has been a change
in the overall price level. Such confusion can lead firms to produce, at least temporarily, the wrong
level of output. And if many firms make these mistakes at the same time then the result is an
unnecessary fluctuation in aggregate output.
Another decision affected by uncertainty about prices is investment. Many investments are specific to
a particular model or product, and so they become sunk costs. For such irreversible investments it
may pay to wait before investing since time will resolve some of the uncertainty. A Premiership football
team may decide to postpone the construction of a new stadium until their survival in the League is
assured. Or a car manufacturer may postpone a decision about opening a new plant to see if a rise in
demand is temporary or appears likely to last. And that uncertainty could stem from a difficulty in
disentangling relative from absolute prices. In the language of finance, there is an option value to
waiting when there is uncertainty about the returns on an irreversible investment.
So a project must offer a rate of return sufficient not only to cover the cost of financing of the project,
but also the option value to waiting. That may explain why surveys of firms show that their hurdle rates
of return are often well in excess of the cost of either equity or debt finance. For example a CBI survey
last year found that the average real hurdle rate for UK firms was 11.3% - down from rates of around
15% in surveys conducted in 1994 - but still well above the cost of financial capital. If uncertainty about
inflation creates an option value to waiting, then it will reduce investment. And there is growing
empirical evidence that inflation is a key explanatory variable for cross-country differences in
investment to output ratios.5
(ii) Redistribution of wealth between debtors and creditors.
Unexpected changes in the price level - the standard of value used to define contracts - produce
arbitrary redistributions of wealth. As Keynes wrote in his powerful advocacy of price stability in A
Tract on Monetary Reform, "We leave saving to the private investor. We leave the responsibility for
setting production to the business man. These arrangements have great advantages. But they cannot
work properly if the money, which they assume as a stable measuring-rod, is undependable.
Unemployment, the precarious life of the worker, the disappointment of expectation, the sudden loss
of savings, the profiteer - all proceed, in large measure, from the instability of the standard of value".
Or, as Lenin remarked, the best way to destroy capitalism is to debauch the currency. It is arguable as
to whether it is high inflation or serious deflation which results in the greater economic damage. In
Europe in the 1920s hyperinflation undermined economic and social arrangements, as it has done
more recently in Latin America. But deflation has proved just as unpopular as inflation. In 274 A.D. the
Roman Emperor Aurelian tried to restore the integrity of the coinage which had been adulterated by
workmen in the Mint. Aurelian exchanged good money for bad, and ordered the destruction of
accounts drawn up in the devalued currency. In the long run the operation restored the value of
money. But in the short run it caused hardship. Gibbon, in his Decline and Fall of the Roman Empire,
observed that "a temporary grievance of such a nature can scarcely excite and support a serious civil
war". Unfortunately, taking a different and more Keynesian view that in the long run we are all dead,
the population at the time rose in insurrection. Many of them found that they were dead in the short run
as well, with seven thousand soldiers and countless civilians perishing during the suppression of the
uprising.
So let us consider the costs of wealth redistributions arising from unanticipated deflation. Such
redistributions can lower aggregate demand. Why? Since it is difficult either to borrow or insure
against uncertain future employment and earnings opportunities, current assets act as a buffer stock
to make it possible to smooth consumption in the face of shocks to future prospects. When net worth
is small it is risky to run down the buffer stock even further, and so the marginal propensity to spend
out of wealth is much higher for households with low net worth than for families whose assets
comfortably exceed their liabilities. If significant numbers of debtors have little net worth - recent
firsttime house-buyers with high debt-to-value ratios are a prime example - then an unanticipated deflation
could cause a sharp fall in aggregate consumption spending.
Such effects can be amplified if spending - consumption or investment - depends on the value of the
assets that are used as collateral for loans. A fall in prices can produce a vicious circle in which the
initial fall in demand lowers asset prices, reducing the value of collateral, which in turn leads borrowers
to repay debt, exacerbating the original decline in aggregate demand. This "debt deflation" was first
formulated clearly by Irving Fisher in the 1930s, and has recently been revived in a more sophisticated
form by Nobu Kiyotaki and John Moore, here at the London School of Economics.
Because deflations are, fortunately, few and far between, there is a lack of hard empirical evidence on
the quantitative significance of debt deflation. In 1993, I argued that the depth of the recession in the
UK and the US in the early 1990s was the result of debt deflation. Consumption fell more sharply than
would have been expected given movements in incomes and interest rates, reflecting an unexpected
fall in inflation and asset prices. The effects on consumption of negative equity in housing were
particularly severe.
The experience of Japan may add to our knowledge in this area, although, as shown in Chart 6,
despite a stagnant economy over the past decade, deflation of consumer prices has not been
especially large. And I am confident that all central banks will do their best to prevent the sample size
of countries suffering from serious deflation from increasing.
Chart 6
Consumption and deflation in Japan,
1985-2002
Note: Inflation is measured using the consumer price index excluding foodstuffs. The
overnight interest rate is the nominal overnight uncollateralised call rate.
Source: Thomson Financial Datastream.
(iii) Aversion to long-term contracts and excessive resources devoted to hedging inflation
risks.
As we have seen, high inflation goes hand in hand with greater uncertainty about future inflation.
Inflation is, therefore, associated with a positive risk premium to compensate investors for that
uncertainty. The longer the time horizon, the greater the risk premium is likely to be. That discourages
long-term contracts and interest rates in such contracts will often depend upon future spot interest
rates. Floating-rate mortgages are a good example. With a floating-rate mortgage the borrower is
exposed to the risk of sharp fluctuations in the proportion of income that is devoted to debt service, as
many households in Britain still remember from the late 1980s when interest rates doubled to 15%.
Fixed-rate mortgages eliminate that risk, but at the cost of introducing a new risk: the real value of the
outstanding debt may change relative to the value of the house. John Campbell and João Cocco
(2002) have suggested that a superior contract would be a fixed-rate mortgage where the principal
was index-linked. That would reduce both income and capital risk. For whatever reason the market
has not generated many private-sector index-linked contracts, despite the encouragement of high
inflation in the past. Perhaps that is because the risks are generated not by some exogenous process,
but by policy decisions. In any event, price stability is a good alternative to indexation.
The move from a regime of high inflation to one of price stability can have consequences which again
are best illustrated by the housing market. A credible move to inflation targeting can bring down
inflation expectations relatively quickly, even if with a lag. Chart 7 shows that inflation expectations, as
measured by surveys, fell steadily following the introduction of inflation targeting, and are now
anchored on the 2.5% target. But a move to low inflation has other consequences that may be less
easily understood. Price stability means lower nominal interest rates, and lower mortgage interest
payments. It may also mean lower real interest rates if the inflation risk premium falls. But the fall in
nominal rates is likely to be much larger than the fall in real rates. The lower mortgage payment largely
reflects a rise in the effective duration of the loan because inflation no longer erodes the real value of
the debt as quickly as before. In a low inflation world, nominal incomes rise more slowly than before
and the real burden of servicing the debt persists. It may take longer for households to work out the
impact of low inflation on real interest rates than to realise that the rate of increase of prices of
everyday purchases has fallen. Learning takes time.
Chart 7
One-year ahead inflation expectations and inflation outturns
in the UK, 1988-2002
Note: Inflation is the four quarter change in the RPI. Expected inflation is based on the
quarterly Barclays Basix survey of inflation one year ahead. It is the weighted average
across all surveyed sub-groups, excluding the general public. Expected inflation is lagged
on year in the chart, so that expectations and outturns for the same period can be
compared.
Source: ONS and Basix.
One possible consequence of a slow adjustment to low inflation is that households may mistake too
much of the reduction in nominal interest rates for a permanent fall in the real rate. As a result, asset
prices are bid up to levels that prove unsustainable when learning finally occurs - and at the LSE you
know that in time we do learn. How far this theoretical argument applies to the British housing market
at present is difficult to say, but it demonstrates the risks from current house price to earnings ratios
that are close to the peaks reached in the late 1980s.
* * *
So much for the costs of unanticipated inflation. What are the costs of anticipated inflation? Time
permits me to comment only briefly on the four costs of anticipated inflation noted by Lord Kingsdown.
(i) Distortions to cash balances
Money - notes and coin - may no longer, as Sally Bowles claimed, make the world go round, but, even
in a world of plastic, it oils the wheels of transactions. Cash still accounts for a large number of
transactions, albeit a smaller fraction of the value of all transactions. The opportunity cost of holding
cash is the interest rate on deposits. Inflation raises nominal interest rates and hence this cost. So
agents economise on their real money balances, and incur additional costs in the form of more
frequent trips to the cash dispenser - the so-called 'shoe-leather costs' of inflation. The traditional view
was that these costs could be measured by the area under the money demand curve. Such estimates
were typically small, and left researchers wondering if the costs of inflation were really all that
important. But high inflation rates can affect more than just money demand. If agents economise on
money balances, transactions costs may rise in markets for goods, labour and assets. As argued by
Hahn (1965) and more recently articulated by Wallace (2001), many monetary models contain hidden
inconsistencies in the sense that they ignore the credit or trade frictions - in particular, imperfect
monitoring and enforceability - that give to money an essential role in the first place. To assess the
welfare implications of inflation we need a theoretical framework that takes seriously the role of money
in all these transactions. I have discussed elsewhere (King, 2001) the potential importance of money
in reducing the transactions costs of firms by reducing liquidity premia in a wide range of financial
markets. There is much to learn here.
(ii) Incomplete indexation of the tax system
A second cost of anticipated inflation is the added inefficiencies that arise when an already
distortionary tax system is incompletely indexed. Martin Feldstein (1999) has edited a major study of
the costs of incomplete indexation which includes a detailed analysis of the tax distortions to saving,
consumption and investment in several major countries, and to which the Bank of England contributed.
The benefit of reducing inflation in an already low inflation environment is estimated to be lower in the
UK than in some other countries because some parts of the tax system are indexed. Nevertheless, the
authors estimate that a reduction in inflation by 2 percentage points would bring an annual benefit
equivalent to 0.2% of GDP. That may sound small, but it is a large absolute number. Against that, the
end of mortgage interest deductibility will have lowered the impact.
(iii) Front-end loading of debt burdens
A third distortion is that of front-loading of the real debt burden when debt contracts are fixed in
nominal terms. Inflation reduces the amount that households borrow because it raises the cost of
servicing the loan in the early years. In this way decisions on consumption and investment may be
distorted.
(iv) Costs of changing price lists
The costs of changing price lists and catalogues - so-called menu costs - are generally agreed to be of
little direct consequence. But they may produce a degree of nominal rigidity in wages and prices which
takes on greater significance. Inflation now causes relative price variability as not all firms are able to
change their prices at the same time. The cost of greater relative price variability was discussed
above, and continues to be an active field of research. Recent work at the Institute of Fiscal Studies
(2002) shows that when inflation is higher, there is a larger dispersion in the inflation rates faced by
individual households. This finding points strongly to the role of nominal rigidities in contributing to
relative price dispersion.
Taken together, the verdict of economics, history and common sense is that inflation and deflation are
costly. It is clear that very high inflation - in extreme cases hyperinflation - can lead to a breakdown of
the economy. There is now a considerable body of empirical evidence that inflation and output growth
are negatively correlated in high-inflation countries. For inflation rates in single figures, the impact of
inflation on growth is less clear. But in a study of 133 market economies over the past 50 years,
Stanley Fischer and his co-authors (2002) concluded that "the old idea that in some sense inflation
may be good for growth or is perhaps an inevitable part of the growth process should remain buried in
the cemetery of harmful policy ideas".
4. Price stability: what does it mean in practice?
So there is a strong case for price stability. But what does price stability mean in practice? Recall that
the definitions of price stability offered by Alan Greenspan and Alan Blinder are rather general in
nature and make no reference to particular indexes of prices or precise numbers for inflation. There
are good reasons for this. The prices of the goods that I buy may rise at a different rate from the goods
that you buy. Relative prices are always changing. And the basket of goods and services that you buy
today is very different from the basket you could or would have bought fifty or a hundred years ago.
The official retail price index now includes computers and cable TV, but no longer bowler hats or the
price of admission to cricket matches. Measurement problems mean that there is no unique way to
calculate inflation.
Information on prices of individual commodities in the past can be found in Harrods catalogues which
were published from the mid-1890s until 1930, catalogues for the Army and Navy Stores from 1872 to
1940, and the advertising records for Selfridges which go back to 1909. To illustrate the problems of
measuring inflation, I shall draw largely on historic price material kindly provided by Harrods - mainly
the Catalogues, Harrods News, and Harrods Food News. No records were published after 1970, so
we have supplemented the historical data by our own researches. And I am very grateful to the young
Bank of England economist who was apprehended in the Food Hall, suspected of comparing prices for
a competitor who was opening a store across the road.
The richness of this information can be seen from the size of the Catalogue for 1907 - weighing over
six pounds and containing 1375 pages. In those days the telegraphic address of Harrods was
"Everything, London". The Internet has nothing on Harrods in 1907 when a telephone service with real
people answering was available to take orders right through the night which were despatched early
the next day with free local delivery (as far as Windsor) and by mail elsewhere.
According to the catalogues, a record player in Harrods cost £11 in 1910 (approximately £627 in
today's money). That would have bought you a hand-cranked machine that provided low-quality
sound. Today, you could buy a record player for as little as £39 on the Internet, and at Harrods a
better quality model for £250. How much have record-players increased in price? Ignoring quality
changes, the price rose by a factor of 3.5 (that is, £39/£11). But ignoring the vast quality improvements
would surely overstate this increase - a quality change bias. So how do we quantify the increase in
the quality of today's record player relative to the one in 1910? Statistically, there are a number of
ways of dealing with this issue: one is to determine the price as a function of characteristics that do not
change over time. The prime example of such hedonic pricing techniques in use today is for pricing
computers, where the quality characteristics - performance in terms of speed and memory - can be
fairly accurately measured. But hedonic pricing i