CALCULATING INFLATION: PRICE CHANGE, CPI, AND THE GDP DEFLATOR

INFLATION FOR A SINGLE GOOD  Inflation is the percent change in prices.  Therefore, in its simplest form, inflation can be calculated as: (Price in Year 2 - Price in Base Year) x 100 Price in Base Year

MEASURING AGGREGATE PRICE CHANGES  How do you measure overall inflation for an entire economy’s worth of goods?  Two most common methods: the Consumer Price Index (CPI) and The GDP Deflator

THE CONSUMER PRICE INDEX (CPI)  Combines the prices of a bundle of goods and services.  Based on a market basket of more than 200 categories of goods and services weighted according to how much the average consumer spends on them.

CONSUMER PRICE INDEX CPI= Cost of market basket in current-year prices x 100 Cost of market basket in base-year prices

DOWNSIDE TO USING CPI  Substitution bias – As the price of a good rises, people will buy more of the good’s substitute. With more of the substitute being purchased, the CPI will account for the substitute and reflect no overall change in the price level of the economy while the original good did in fact change in price.

DOWNSIDE TO USING CPI  Introduction of new goods – When new goods are introduced to an economy, they typically have a short-term high price. Over time, the price decreases to an equilibrium price. The CPI often accounts for the good at its high price, consequently creating a higher price level than what is accurate.

DOWNSIDE TO USING CPI  Improvement in quality – The CPI does not account for changes in quality of goods and services. When incomes are high, people will buy more luxury goods while non-luxury versions of the same goods are available. The CPI will increase as average prices of the goods increase because more people buy the luxury version. This leads to an increase in the CPI when prices may not have necessarily changed at all.

GDP DEFLATOR  GDP deflator measures price changes in current year compared to those in a base year FOR ALL GOODS AND SERVICES produced within the economy.

GDP DEFLATOR  To Calculate: Nominal GDP x 100 Real GDP

CPI VS. GDP DEFLATOR CPIGDP Deflator Is calculated based on a FIXED BASKET of goods and services The data is not based on a basket of goods but on the economy as a whole Much simpler for Economists to calculate and the data is available much sooner than GDP Deflator data. GDP Deflator is not affected by changes in tastes or the introduction of new products in the market

USING THE CPI AND GDP DEFLATOR TO CALCULATE INFLATION  Inflation rate = Price Index year 2 – Price Index year 1 Price Index year 1

USING PRICE INDICES TO CALCULATE REAL GDP  Price Index = Therefore…  Real GDP =

ASSIGNMENT  Complete page of the packet you received on Thursday  Complete problems 3, 7, and 10 on pages (due Wednesday)  Read Modules 12 and 13 for Wednesday.  Quiz Wednesday on calculating GDP and Inflation.