2.4 - Price Indices and Inflation

Defining Inflation and Loss of Purchasing Power

Inflation isn’t the same as a single good’s price rising due to its own supply and demand shifts. Inflation is a sustained increase in the overall price level across the economy, a broad increase, not just one product going up. You can also think of it as a loss of purchasing power: if inflation hits, a fixed amount of money won’t buy as much as it used to.

The Consumer Price Index (CPI)

The CPI is the most common way to measure inflation. It tracks the cost of a market basket of goods meant to represent what a typical urban American family buys, things like housing, food, transportation, and health services. The idea is to see how much the same basket costs over time.

Cost of the Market Basket: you use the prices from the given year, but the quantities from the base year. Using base-year quantities as a control keeps the focus on price changes, not shifts in what people are buying.

Calculating CPI:

CPI = \left(\frac{\text{Cost of Market Basket in Given Year}}{\text{Cost of Market Basket in Base Year}}\right) \times 100

The CPI in the base year always equals 100, and CPI has no dollar sign or percent symbol attached.

What the number means: a CPI of 125 means the same basket costs 25% more than in the base year. So a consumer would need 25% more income than in the base year to keep the same standard of living.

Calculating the Inflation Rate:

\text{Inflation Rate} = \left(\frac{\text{CPI in Second Year} - \text{CPI in First Year}}{\text{CPI in First Year}}\right) \times 100

This formula works for any price index, including the GDP deflator (see 2.6). Always divide by the earlier year’s index. That’s only 100 if the earlier year is the base year.

Example: the market basket is 10 burgers and 4 movie tickets, and Year 1 is the base year.

Year	Burger price	Ticket price	Cost of the basket	CPI
Year 1 (base)	$10	$15	10($10) + 4($15) = $160	100
Year 2	$12	$16	10($12) + 4($16) = $184	115
Year 3	$12	$20	10($12) + 4($20) = $200	125

CPI in Year 2 $= \frac{184}{160} \times 100 = 115$

Inflation rate from Year 1 to Year 2 $= \frac{115 - 100}{100} \times 100 = 15\%$

Inflation rate from Year 2 to Year 3 $= \frac{125 - 115}{115} \times 100 \approx 8.7\%$ (not 10%, since you divide by 115)

Real variables: a nominal variable is measured in the dollars of its own year. A real variable is the nominal value deflated by the price level, so it shows what the money can actually buy:

\text{Real Value} = \frac{\text{Nominal Value}}{\text{Price Index}} \times 100

This is how you compare dollar amounts from different years. Say you earned $12 an hour in the base year (CPI = 100) and earn $15 an hour now, when the CPI is 130. Your real wage now is

\frac{15}{130} \times 100 \approx \$11.54

in base-year dollars. Your nominal wage went up 25%, but prices went up 30%, so your real wage actually fell (by about 3.8%). There’s more practice with real wages and real income in 2.6.

Weaknesses of the CPI

Substitution bias: the CPI tracks the exact same basket every time, but people naturally substitute away from goods that get more expensive, like buying chicken instead of pricier pork. Because the CPI doesn’t account for this, it tends to overstate the true inflation rate.

Quality changes: the CPI doesn’t properly account for quality improvements. A modern phone costs more but does so much more than older devices, yet the CPI only registers the higher dollar cost.

New products: when a new good comes out, consumers get more choices, which makes each dollar worth more to them. A fixed basket doesn’t pick that up right away, which is another reason the CPI tends to overstate the true inflation rate.

Other Concepts

GDP Deflator: another way to measure inflation.

It covers the prices of all final goods and services produced in the country (consumer goods, investment goods, and government purchases), not just a consumer’s basket. It’s found from nominal and real GDP (see 2.6), and the inflation rate formula above works the same way with it.

Deflation: when the overall price level falls. Money becomes more valuable and things get cheaper in dollar terms. Don’t confuse this with disinflation.

Disinflation: when the inflation rate falls but stays positive. Prices are still rising, just more slowly. If inflation goes from 6% to 3%, that’s disinflation. If it goes from 2% to $-1\%$ , that’s deflation, since prices are now actually falling.

Takeaway

Inflation is a sustained, broad rise in the price level, measured mainly through the CPI, which uses base-year quantities to isolate price changes. But the CPI overstates true inflation because of substitution bias and its failure to capture quality improvements.

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