Key points

Price level is measured by constructing a

hypothetical basket of goods and servicesmeant to
represent a typical set of consumer purchasesand
calculating how the total cost of buying that basket of
goods increases over time.

The rate of inflation is measured as the percentage

change between price levels over time.

An index number is a unit-free number derived from

the price level over a number of years that makes
computing inflation rates easier.

Inflation is the general and ongoing rise in the level of

prices in an economy.

Tracking inflation
When you hear about inflation at the dinner table, it's often
a conversation about how everything seemed to cost so
much less in the past, how you used to be able to buy three
gallons of gasoline for a dollar and then go see an
afternoon movie for another dollar.

The table below compares some prices of common goods in

1970 and 2014but keep in mind that the average prices
shown may not reflect the prices where you live. The cost
of living in New York City is much higher than in Houston,
Texas, for example. In addition, certain products have
evolved over recent decades. A new car in 2014loaded
with antipollution equipment, safety gear, computerized
engine controls, and many other technological advancesis
a more advanced machine and more fuel efficient than your
typical 1970s car.

Let's put details like these to one side for the moment,
however, and look at the overall pattern. The primary
reason behind the price increases in the tableand
increases in prices of other products in the economy not
shown hereis not specific to the market for housing or
cars or gasoline or movie tickets. Instead, it is part of a
general rise in the level of all prices.

In 2014, one dollar had about the same purchasing power

in overall terms of goods and services as 18 cents did in
1972 because of the amount of inflation that has occurred
over that time period.

Item 1970 2014

Pound of ground beef $0.66 $4.16

Pound of butter $0.87 $2.93

Movie ticket $1.55 $8.17

$22,0 $280,00
Sales price of new home, median 00 0

$3,00
New car 0 $32,531

Gallon of gasoline $0.36 $3.36

Average hourly wage for a

manufacturing worker $3.23 $19.55

Per capita GDP $5,06 $53,041

 Item 1970 2014
Pound of ground beef $0.66 $4.16

9 .98
Price comparisons, 1970 and 2014
Additionally, the power of inflation does not affect just
goods and services but wages and income levels, too. The
second-to-last row of the table above shows that the
average hourly wage for a manufacturing worker increased
nearly six-fold from 1970 to 2014. Sure, the average worker
in 2014 is better educated and more productive than the
average worker in 1970but not six times more productive.
And yes, per capita gross domestic product increased
substantially from 1970 to 2014, but is the average person
in the US economy really more than eight times better off in
just 44 years? Not likely.

A modern economy has millions of goods and services

whose prices are continually quivering in the breezes of
supply and demand. How can all of these shifts in price be
boiled down to a single inflation rate? As with many
problems in economic measurement, the conceptual
answer is reasonably straightforward. Prices of a variety of
goods and services are combined into a single price level.
The inflation rate is the percentage change in the price
level. Applying the concept, however, involves some
practical difficulties.

The price of a basket of goods

To calculate the price level, economists begin with the
concept of a basket of goods and services that consists of
the different items individuals, businesses, or organizations
typically buy. The next step is to look at how the prices of
those items change over time.

In thinking about how to combine individual prices into an

overall price level, many people find that their first impulse
is to calculate the average of the prices. Such a calculation,
however, could easily be misleading because some
products matter more than others.

Changes in the prices of goods for which people spend a

larger share of their incomes will matter more than changes
in the prices of goods for which people spend a smaller
share of their incomes. For example, an increase of 10% in
the rental rate on housing matters more to most people
than whether the price of carrots rises by 10%. To construct
an overall measure of the price level, economists compute
a weighted average of the prices of the items in the basket,
where the weights are based on the actual quantities of
goods and services people buy.

Index numbers
The numerical results of a calculation based on a basket of
goods can get a little messy. To simplify the task of
interpreting the price levels for realistically complex
baskets of goods, the price level in each period is typically
reported as an index number, rather than as the dollar
amount for buying the basket of goods.
Price indices are created to calculate an overall average
change in relative prices over time. To convert the money
spent on the basket to an index number, economists
arbitrarily choose one year to be the base year, or starting
point from which we measure changes in prices. The base
year, by definition, has an index number equal to 100.

This might sound strange, but it's really just a math trick to
simplify things. Let's try it out. Let's say we choose a base
year in which $107 is spent. We divide that amount by itself
$107and multiply by 100, which gives us an index in
the base year of 100. Note that the index number in the
base year always has to have a value of 100.

Then, to figure out the values of the index numbers for the
other years, we divide the dollar amounts for the other
years by 1.07the amount spent during the base year
divided by 100. Note also that the dollar signs cancel out,
so index numbers have no units.

Take a look at the table below. You'll see that in our

example, we've chosen period three as our base year
notice that total spending is $\107. The index numbers for
the other three periods in the table were calculated using
the same method we used above. Andbecause the index
numbers are calculated so that they are in exactly the
same proportion as the total dollar cost of purchasing the
basket of goodsthe inflation rate can be calculated based
on the index numbers, using the percentage change
formula.

Summary
 Price level is measured by constructing a
hypothetical basket of goods and servicesmeant to
represent a typical set of consumer purchasesand
calculating how the total cost of buying that basket of
goods increases over time.

The rate of inflation is measured as the percentage

change between price levels over time.

An index number is a unit-free number derived from

the price level over a number of years that makes
computing inflation rates easier.

Inflation is the general and ongoing rise in the level of

prices in an economy.