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How is price level change measured?
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Price-level change is measured as the percentage rate of change in the level of prices. But how do we find a price level? Economists measure the price level with a price index.
Apr 10, 2024 · What is the effect of an increase in the price level? Price level signifies the average prices of goods and services produced in an economy. An increase in this level will enhance the money demand, extrapolate interest rates, and reduce investment spending plus consumer spending power.
- Overview
- Lesson overview
- The Consumer Price Index (CPI)
- How the CPI is calculated
- How the CPI is used to calculate the rate of inflation
- Adjusting nominal variables into real variables
- The shortcomings of CPI as a measure of the cost of living
- Key Equations
- Common Misperceptions
- Discussion Questions:
In this lesson summary review and remind yourself of the key terms and calculations used in measuring inflation. Topics include the consumer price index (CPI), calculating the rate of inflation, the distinction between inflation, deflation, and disinflation, and the shortcomings of the CPI as a measure of the cost of living.
Lesson overview
You just got a raise! But wait: was that raise really a raise? The third of our three key macroeconomic indicators, the inflation rate, can help you figure that out. Inflation is an increase in the overall price level. The official inflation rate is tracked by calculating changes in a measure called the consumer price index (CPI). The CPI tracks changes in the cost of living over time. Like other economic measures it does a pretty good job of this. But it does have some limitations, such as substitution bias, which can overstate how much the cost of living really has changed.
Key Terms
You just got a raise! But wait: was that raise really a raise? The third of our three key macroeconomic indicators, the inflation rate, can help you figure that out. Inflation is an increase in the overall price level. The official inflation rate is tracked by calculating changes in a measure called the consumer price index (CPI). The CPI tracks ch...
The Consumer Price Index (CPI) measures the change in income a consumer needs to maintain the same standard of living over time. The CPI is meant to reflect changes in the cost of living for a typical urban household.
For example, suppose every household buys 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog treats every week. A consumer price index tracks changes in the price of this unchanging collection of goods over time to measure changes in the cost of living for this household. Once the CPI is calculated for two years, we can to calculate the rate of inflation.
Let’s use the example above of the “basket of goods” consisting of 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog food treats. Once the prices of the goods are calculated, the price of the basket in that year is compared to the price of the basket in some base year.
[Show me how to do it!]
The inflation rate is determined by calculating the percentage change in a price index (such as CPI or the GDP deflator). The inflation rate tells us the percentage by which the price level is changing from period to period.
[Uh, how do I do that?]
Real variables are nominal variables deflated by the price level. Examples of real variables are a real wage or a real interest rate. For instance, the sign at the bank says that they are paying 8% interest, but what are really earning?
If we want to find the real interest rate (the one that reflects what people are actually earning on money deposited in the bank), then we want to take away the effect of inflation. We do so because inflation reduces the purchasing power of the money deposited.
If the interest rate the bank gives us (the nominal interest rate) is 8% , but the rate of inflation is 5% , we are really earning 8%−5%=3% on the money that we put in the bank. Why? Because that is how much more we can buy when we take our money out after a year.
[How does that work?]
Using the CPI as a measure of inflation has some shortcomings. That can cause the CPI to overstate the true inflation rate. For example,
causes the CPI to overstate increases in the cost of living. When the prices of goods go up, people will substitute other similar goods in place of the good that is now more expensive. But because the CPI assumes that the basket of goods never changes, it makes it appear that people always buy the same amount of a good that is now more expensive.
For any year, t :
CPIt=Cost of basket in year tCost of basket base year×100Inflation rate=CPInew−CPIoldCPIold×100
•If there is 2% inflation every year for five years, then after ten years the price level has gone up to 20% , right? No! Inflation compounds over time. For example, suppose a chicken coop costs $100 and there is 2% inflation, that means that after a year the chicken coop will cost $102 . If inflation continues at 2% for another year, the $102 grows by 2% , not the original price. In fact, if there is 2% inflation every year for 10 years, the chicken coop will cost $121.90 , 21.9% more than the original price.
•The term “index” might sound strange, but an index is simply any measure that compares a value in one period to the value in a base year.
•Another common misperception is that once we calculate the CPI, we have the rate of inflation between any two years. That is a necessary step, but it is not the final step. We must then use the CPI in both years to calculate the rate of inflation.
•There are actually several different price indices used to calculate the rate of inflation. The CPI is the one that is used to calculate the official rate of inflation, which is why you’ll often hear it reported in the news.
•What are some reasons that the CPI might not capture the true rate of inflation?
•How might changes in spending habits of households over a 20 year period change? How does this impact CPI as a measure of the cost of living?
•The CPI in the nation of Montrose was 220 in 2016 and 200 in 2015. What is the rate of inflation between 2015 and 2016?
[You got me. HELP!]
Using the statistics on real GDP and nominal GDP, one can calculate an implicit index of the price level for the year. This index is called the GDP deflator and is given by the formula. The GDP deflator can be viewed as a conversion factor that transforms real GDP into nominal GDP.
Price level is measured by constructing a hypothetical basket of goods and services —meant to represent a typical set of consumer purchases—and 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.
Jul 17, 2023 · LibreTexts. Learning Objective. Define inflation and deflation, explain how their rates are determined, and articulate why price-level changes matter. Explain what a price index is and outline the general steps in computing a price index. Describe and compare different price indexes.
Nov 21, 2020 · Price levels are leading indicators in the economy; rising prices indicate higher demand leading to inflation while declining prices indicate lower demand or deflation.
