Measuring Inflation

Measuring Inflation Warning: May not be suitable for SL students

How to measure Inflation? We know that inflation is a continuing increase in the general price level. But prices of goods and services are always changing, so how do we calculate an accurate measure of an overall change in prices?

Price indexes to the rescue

What’s a price index? A measure of average prices in one period relative to the average prices in a reference period, (or base year)

There are two main types of price indexes…..

Consumer Price Index (CPI) The CPI (used in the U.S.A.) is a measure of the cost of goods and services purchased by the typical household, aka the Retail Price Index (RPI) in the U.K.

So how do they work? The CPI and RPI relate the average prices of thousands of goods and services in a given year to the average prices of the same basket in the base year

Can we see an example please?

Is it really that easy? No, that’s a simplified example. Statisticians calculate the price of thousands of goods and then weight the value of each item in the basket, but that is more than we have to know….

And please remember…. If you are going to compare CPI numbers, they must reference the same base year and compare the same basket of goods in order to compare one year to another

The GDP deflator This is an alternate way to measure the average level of prices of all goods and services included in GDP

GDP deflator GDP deflator = nominal GDP/real GDP X 100. So if nominal GDP was $1160 in 2002, but real GDP was $976, the GDP deflator would equal 118.8

Comparing GDP deflator values A GDP deflator value of 118.8 would tell us that inflation has increased 18.8% since the base year.

Comparing GDP deflator values If the GDP deflator in 2002 was 118.8 and in 2003 it was 130, we would calculate as follows: 130-118.8/118.8 X 100 = 9.4%

Shortcomings of the CPI And sadly, there are many…

Problem # 1 Weighting values of goods are established in the base year. If the price of one good rises, consumers will choose a substitute good. however, this change in purchasing habits is not captured by CPI

Problem #2 Stores often run sales which allow consumers to buy products at prices lower than that reported by CPI. This is another example of how CPI may overstate inflation

Problem #3 Because CPI operates with a fixed basket of goods and services, new products introduced are not surveyed and goods that become less popular are not immediately replaced in the basket

Problem #4 The CPI cannot account for quality changes over a period of time.

Additional problems CPI doesn’t account for purchasing variations based on geography, and is not very reliable when doing international comparisons

The GDP deflator has flaws too…. The GDP deflator measures current output at base year prices, so it overcomes the problems associated with a fixed basket of goods. However, it has other weaknesses…

GDP deflator weaknesses The GDP deflator measures all goods and services included in GDP. Why might this not be relevant to consumers?

The GDP deflator and weighting The GDP deflator doesn’t weight goods based on their importance to average households, therefore is not particularly relevant to consumers.

Final Words…. The CPI reflects changes in the cost of living for consumers, the GDP deflator reflects changes in average prices for the economy as a whole, so CPI is more commonly used.

Measuring Inflation