Module The Measurement and Calculation of Inflation 15 Module The Measurement and Calculation of Inflation KRUGMAN'S MACROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How is the inflation rate is measured? What is a price index and how it is calculated? What are inflation indexes, and why should we care?

How do we measure inflation? Price Index  2 types  basket of goods Note: it is a good idea to use an example similar to the one below to demonstrate how economists construct a price index for the purpose of tracking inflation.   With millions of products being purchased throughout the day and across America, how can we tell if overall prices are rising or falling? And if they are rising, are they rising quickly or slowly? We first need to figure out what Americans are buying in their “market basket”, and then we determine the prices of those goods, and then compile this information into one statistic: a price index.

Market Baskets and Price Indexes Consumers buy all sorts of different goods and services in a typical year. This typical basket of goods and services purchased is called the market basket. Market Basket Go to pic

Market Baskets and Price Indexes Price Index in given year = Cost of market basket in a given year Cost of market basket in base year X 100 In general, a price index is computed by constructing this ratio:   Price Index in year t = 100*(Cost of the market basket in year t)/(Cost of the market basket in the base year) The base year is the benchmark year. All other years, past and future, are compared to the base year to see if the market basket was more or less expensive than it was in that year. Use 2008 as the base year. DPI2008 = 100*($3900)/($3900) = 100 NOTE: any price index is always 100 in the base year. DPI2009 = 100*($4600/($3900) = 117.9 Calculating the inflation rate is just calculating the percentage change between any two values of the price index. Inflation from 2009 to 2008 = 100*(DPI2009 – DPI2008)/(DPI2008) = 100*(117.9-100/100) = 17.9% Inflation Rate = Price index in year 2 - Price index in year 1 Price index in year 1 X 100

What’s the relationship? Price Index in given year = Cost of market basket in a given year Cost of market basket in base year X 100 Real In general, a price index is computed by constructing this ratio:   Price Index in year t = 100*(Cost of the market basket in year t)/(Cost of the market basket in the base year) The base year is the benchmark year. All other years, past and future, are compared to the base year to see if the market basket was more or less expensive than it was in that year. Use 2008 as the base year. DPI2008 = 100*($3900)/($3900) = 100 NOTE: any price index is always 100 in the base year. DPI2009 = 100*($4600/($3900) = 117.9 Calculating the inflation rate is just calculating the percentage change between any two values of the price index. Inflation from 2009 to 2008 = 100*(DPI2009 – DPI2008)/(DPI2008) = 100*(117.9-100/100) = 17.9% Nominal GDP in a given year Real GDP in a given year Inflation GDP Price Index in a given year Nominal (Algebra Magic) Nominal GDP in a given year Price Index in a given year Real GDP in a given year Price Indices

What’s the difference? In theory, they are different. In practice, they are extremely similar. GDP deflator uses a base year compared to the current as a measure of inflation, for ALL GOODS AND SERVICES. Price index uses a base year compared to the current year, for A LIST OF SPECIFIC GOODS AND SERVICES. In general, a price index is computed by constructing this ratio:   Price Index in year t = 100*(Cost of the market basket in year t)/(Cost of the market basket in the base year) The base year is the benchmark year. All other years, past and future, are compared to the base year to see if the market basket was more or less expensive than it was in that year. Use 2008 as the base year. DPI2008 = 100*($3900)/($3900) = 100 NOTE: any price index is always 100 in the base year. DPI2009 = 100*($4600/($3900) = 117.9 Calculating the inflation rate is just calculating the percentage change between any two values of the price index. Inflation from 2009 to 2008 = 100*(DPI2009 – DPI2008)/(DPI2008) = 100*(117.9-100/100) = 17.9%

It’s all relative… Inflation changes purchasing power Ratio - Δwage : Δinflation As we showed with the DPI, a price index can be created for anything. Two are commonly used, with the CPI, to gauge changes in the aggregate price level.   The Producer Price Index (PPI) measures the cost of a typical basket of goods and services—containing raw commodities such as steel, electricity, coal, and so on—purchased by producers. The GDP deflator is technically not a price index, but it is used in the same way. For a given year the GDP deflator is equal to 100 times the ratio of nominal GDP for that year to real GDP for that year expressed in prices of a selected base year. Since real GDP is currently expressed in 2000 dollars, the GDP deflator for 2000 is equal to 100. If nominal GDP were to increase by 5%, but real GDP does not change, the GDP deflator indicates that the aggregate price level increased by 5%.

Practice Calculate the GDP deflator for the missing years. CPI 2014 301.5 2015 100 310 2016 299 When we talk about inflation, we are usually talking about rising prices for things that we all consume.   This Consumer Price Index (CPI) is the most widely used measure of price inflation. It is computed every month and uses prices for a market basket of about 80,000 goods and services that a typical urban family of four consumes. Note: If the instructor is pressed for time, it is my advice to not dwell on the statistical weaknesses of the CPI. I don’t believe it is likely testable on the AP exam, and the CPI has recently been improved to address most of the criticisms. Calculate the GDP deflator for the missing years. Why does 2015 =100? Give me the inflation rate for each 2014-2015 and 2015-2016 based on the GDP deflator.