Measuring the Economy 2

Inflation
Things cost more today than they used to. In the 1920's, a loaf of bread cost about a nickel. Today it costs more than $1.50. In general, over the past 300 years in the United States the overall level of prices has risen from year to year. This phenomenon of rising prices is called inflation. While small changes in the price level from year to year may not be that noticeable, over time, these small changes add up, leading to big effects. Over the past 70 years, the average rate of inflation in the United States from year to year has been a bit under 5 percent. This small year-to-year inflation level has led to a 30-fold increase in the overall price during that same period. Inflation plays an important role in the macroeconomic economy by changing the value of a dollar across time. This section on inflation will deal with three important aspects of inflation. First, it will cover how to calculate inflation. Second, it will cover the effects of inflation calculations using the CPI and GDP measures. Third, it will introduce the effects of inflation. Calculating inflation Inflation is the change in the price level from one year to the next. The change in inflation can be calculated by using whatever price index is most applicable to the given situation. The two most common price indices used in calculating inflation are CPI and the GDP deflator. Know, though, that the inflation rates derived from different price indices will themselves be different. Calculating Inflation Using CPI The price level most commonly used in the United States is the CPI, or consumer price index. Thus, the simplest and most common method of calculating inflation is to calculate the percentage change in the CPI from one year to the next. The CPI is calculated using a fixed basket of goods and services; the percentage change in the CPI therefore tells how much more or less expensive the fixed basket of goods and services in the CPI is from one year to the next. The percentage change in the CPI is also known as the percentage change in the price level or as the inflation rate. Fortunately, once the CPI has been calculated, the percentage change in the price level is very easy to find. Let us look at the following example of "Country B."

Figure %: Goods and Services Consumed in Country B Over time the CPI changes only as the prices associated with the items in the fixed basket of goods change. In the example from Country B, the CPI increased from 100 to 141 to 182 from time period 1 to time period 2 to time period 3. The percent change in the price level from the base year to the comparison year is calculated by subtracting 100 from the CPI. In this example, the percent change in the price level from time period 1 to time period 2 is 141 - 100 = 41%. The percent change in the price level from time period 1 to time period 3 is 182 - 100 = 82%. In this way, changes in the cost of living can be calculated across time.

These changes are described by the inflation rate. That is, the rate of inflation from period 1 to period 2 was 41% and the rate of inflation from period 1 to period 3 was 82%. Notice that the inflation rate can only be calculated using this method when the same base year is used for all of the CPI's involved. While it is simple to calculate the inflation rate between the base year and a comparison year, it is a bit more difficult to calculate the rate of inflation between two comparison years. To make this calculation, first check that both comparison years use the same base year. This is necessary to ensure that the same fixed basket of goods and services is used. Next, to calculate the percentage change in the level of the CPI, subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year. In the example from Country B, the CPI for period 2 was 141 and the CPI for period 3 was 182. Since the base year for these CPI calculations was period 1, we must use the method of calculating inflation that takes into account the presence of two comparison years. We need to subtract the CPI for the later year from the CPI for the earlier year and then divide by the CPI for the earlier year. That gives (182 - 141) / 141 = 0.29 or 29%. Thus, the rate of inflation from period 2 to period 3 was 29%. Notice that this method works for calculating the rate of inflation between a base year and a comparison year as well. For instance, the CPI for period 1 was 100 and the CPI for period 2 was 141. Using the formula above gives (141 - 100) / 100 = 0.41 or 41%.