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## 3.2 Measuring Prices and Inflation

### Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. How are price indices such as the Consumer Price Index (CPI) calculated?
2. What is the difference between the CPI and gross domestic product (GDP) deflator?
3. What are some of the difficulties of measuring changes in prices?

If nominal GDP increased in Argentina but real GDP did not, then prices must have increased. So now we look in more detail at the measurement of prices.

## The Price Index

Remember that we defined the change in prices as follows:

We can use the data in Table 3.1 "Calculating Nominal GDP" to calculate this ratio as well. This time, however, we compare the cost of the same basket of goods (in this case, output in 2013) according to the prices prevailing at two different times. The basket of goods in 2013 is shown in Table 3.4 "Calculating the Price Index" as the quantities of the three goods and services produced that year: 12 T-shirts, 60 music downloads, and 5 meals. As we saw earlier, the cost in dollars of this basket of goods and services is $442. Table 3.4 Calculating the Price Index Year T-shirts Music Downloads Meals Cost of 2013 Basket ($) Price Index
Price ($) Quantity Price ($) Quantity Price ($) Quantity 2012 20 12 1 60 25 5 425 1.00 2013 22 12 0.80 60 26 5 442 1.04 Table 3.4 "Calculating the Price Index" also shows the total cost of consuming the 2013 basket in 2012, which we already know is$425. Thus the price index for 2012 is $425/$425 = 1, and the price index for 2013 is $442/$425 = 1.04.Frequently, the value for the price index is multiplied by 100, so the price index for 2013 would be given as 104. For the simple three-good economy described in Table 3.1 "Calculating Nominal GDP", we therefore have the following:

Prices increased by 4 percent, real GDP increased by 6.25 percent, and nominal GDP increased by 10.5 percent.

To summarize, the basic principle for calculating inflation is as follows: (1) We decide on a bundle of goods and look at how much it costs in a given year. (2) Then we look at the same bundle of goods in the following year and see how much it costs. (3) The ratio of the two is called a price indexA measurement of the cost of a bundle of goods in a particular year relative to a base year. and provides a measure of one plus the inflation rateThe growth rate of the price index from one year to the next..

A price index for a given year is calculated as the cost of a bundle of goods in that year divided by the cost of the same bundle in the base year. The growth rate of the price index from one year to the next is a measure of the inflation rate.

## Different Price Indices

There are many different price indices that are constructed and used for different purposes. They can be constructed for particular categories of goods or regions, for example. If you listen to the news, you may hear references to the Producer Price Index or the Wholesale Price Index. Ultimately, the differences among different price indices simply come down to the bundle of goods that is chosen.

But then you start to worry. The 2011 ThinkPad is nothing like the 1992 version. The 1992 computer had 120 MB of memory and weighed over 5.5 pounds. The 2011 ThinkPad has 4 GB of memory and weighs 2 pounds less. It has a vastly bigger hard drive, wireless Internet connection, and a superior display. In short, there were huge quality improvements over this period. A computer with the specifications of the 1992 ThinkPad would be worth much less than $899. By ignoring the improvements in quality, you have understated how much the price of computers has fallen. This problem is particularly acute for computers, but it applies to all sorts of different goods. The new car that you purchase today is very different from a car that your mother or your grandfather might have bought. Cars today come equipped with computerized braking systems, global positioning system (GPS) navigational tools, and numerous other sophisticated engineering features. They are also much more reliable; your grandparents will tell you that cars used to break down all the time, whereas now that is a relatively rare event. It would be a big mistake to say that a 2012 automobile is the same as a 1961 automobile. 2. New goods and old goods. The typical basket of goods bought by consumers is changing. In 1970, no one had a mobile phone, an MP3 player, or a plasma television. Similarly, people today are not buying vinyl records, videocassette recorders, or Polaroid cameras. The BLS needs to keep up with every change. As the economy evolves and new goods replace old ones, they must change the basket of goods. 3. Changes in purchasing patterns. The bundle purchased by the typical household also changes over time because of changes in the prices of goods and services. The typical household will substitute away from expensive goods to relatively cheaper ones. If the basket of goods is held fixed, the calculation of the CPI will overstate the increase in the cost of living. This effect is most severe if there are two goods that are very close substitutes and the price of one increases significantly relative to another. Perhaps these seem like minor details in the calculation of the CPI. They are not. A government commission chaired by the economist Michael Boskin provided an extensive report on biases in computing the CPI in 1996. The Boskin Commission concluded the following: “The Commission’s best estimate of the size of the upward bias looking forward is 1.1 percentage points per year. The range of plausible values is 0.8 to 1.6 percentage points per year.” That is, the Boskin Commission concluded that if inflation as measured by the CPI was, say, 3.1 percent, the true inflation rate was only 2 percent. In response to these concerns with measurement, the BLS responded by taking actions to reduce the biases in the measurement of the CPI and deal more effectively with the introduction of new goods.For the complete Boskin Commission Report, see Advisory Commission to Study the Consumer Price Index, “Toward a More Accurate Measure of the Cost of Living,” Social Security Administration, December 4, 1996, accessed June 28, 2011, http://www.ssa.gov/history/reports/boskinrpt.html. For the BLS response to the report, see “Consumer Price Index: Executive Summary,” Bureau of Labor Statistics, October 16, 2011, accessed June 28, 2011, http://www.bls.gov/cpi/cpi0698b.htm. ## Correcting for Inflation The data on nominal and real GDP in Argentina illustrate the dangers of looking at nominal rather than real variables. Had you looked at only nominal GDP, you would have concluded that the Argentine economy had been growing between 1993 and 2002, when it was actually stagnating. But many economic statistics—not only nominal GDP—are typically quoted in terms of dollars (pesos, euros, ringgit, or whatever the currency of the country is). To make sense of such statistics, we must understand whether changes in these statistics represent real changes in the economy or are simply a result of inflation. If you have some data expressed in nominal terms (for example, in dollars) and you want to covert them to real terms, use the following steps. 1. Select your deflator. In most cases, the CPI is the best deflator to use. 2. Select your base year. Find the value of the index in that base year. 3. For all years (including the base year), divide the value of the index in that year by the value in the base year. (This means that the value for the base year is 1.) 4. For each year, divide the value in the nominal data series by the number you calculated in Step 3. This gives you the value in base year dollars. Here is an example of how to correct for inflation. Suppose that a sales manager wants to evaluate her company’s sales performance between 2000 and 2005. She gathers the sales data shown in Table 3.5 "Sales, 2000–2005". Table 3.5 Sales, 2000–2005 Year Sales (Millions of Dollars) 2000 21.0 2001 22.3 2002 22.9 2003 23.7 2004 24.1 2005 24.7 At first glance, these numbers look reasonably encouraging. Sales have grown every year between 2000 and 2005. But then she remembers that these data are in nominal terms, and there was also some inflation over this time period. So she decides to correct for inflation. She first goes to the Economic Report of the President and downloads the data in Table 3.6 "Consumer Price Index, 2000–2005".See Economic Report of the President, 2011, Table B-60, accessed June 28, 2011, http://www.gpoaccess.gov/eop. She decides to use 2000 as the base year—she wants to measure sales in year 2000 dollars. So there are two steps to her calculations, as shown in Table 3.7 "Sales Data Corrected for Inflation, 2000–2005". First, she takes the CPI series and divides every term by the 2000 value (that is, 172.2). This gives the third column of Table 3.7 "Sales Data Corrected for Inflation, 2000–2005", labeled “Price Index.” Then she divides each of the sales figures by the corresponding price index to obtain the real (that is, corrected for inflation) value of sales. These are given in the final column of the table. Table 3.6 Consumer Price Index, 2000–2005 Year CPI 2000 172.2 2001 177.1 2002 179.9 2003 184.0 2004 188.9 2005 195.3 Table 3.7 Sales Data Corrected for Inflation, 2000–2005 Year CPI Price Index (Base = 2000) Sales (Millions of Dollars) Real Sales (Millions of Year 2000 Dollars) 2000 172.2 1.00 21.0 21.0 2001 177.1 1.03 22.3 21.7 2002 179.9 1.04 22.9 21.9 2003 184.0 1.06 23.7 22.2 2004 188.9 1.10 24.1 22.0 2005 195.3 1.13 24.7 21.8 We can see that the sales data are much less rosy after we account for inflation. Sales were increasing between 2000 and 2003 in real terms, but real sales decreased in 2004 and 2005. Had she just looked at the dollar measure of sales, she would have completely missed the fact that the business had experienced a downturn in the last two years. Economic statistics reported in the news or used by businesspeople are very often given in nominal rather than real terms. Perhaps the single most important piece of “economic literacy” that you can learn is that you should always correct for inflation. Likewise, you should be on your guard for misleading statistics that fail to make this correction. Here is an example from an article that appeared in the Washington Post. “The Clinton recovery has been far less egalitarian than the much-criticized Reagan ‘era of greed.’ Between 1990 and 1995, the [real average] family income actually declined slightly while the number of people with a net worth over$1 million more than doubled.”See J. Kotkin and D. Friedman, “Keep the Champagne on Ice,” The Washington Post, reprinted in The Guardian Weekly, June 7, 1998. In fact, the quote in the newspaper was even more misleading because it did not even make it clear that the family income figure was adjusted for inflation.

Can you see why this sentence is so misleading? It mixes together a real measure and a nominal measure in the same sentence. Real family income—that is, family income corrected for inflation—declined in the first half of the 1990s. But the number of millionaires is a nominal measure. In a time of inflation, we would expect to have more millionaires, even if people are not really getting any richer.

### Key Takeaways

• A price index is created by calculating the cost of purchasing a fixed basket of goods in different years.
• The CPI is a price index for goods and services, including imported goods, consumed by households, while the GDP deflator is based on all the goods and services that compose GDP.
• Calculating a price index is difficult due to the introduction of new products, quality changes, and changes in purchasing patterns.

1. The BLS has an inflation calculator on its website (http://data.bls.gov/cgi-bin/cpicalc.pl), which is shown in Figure 3.10 "BLS Inflation Calculator".

Figure 3.10 BLS Inflation Calculator

You enter an amount and two different years, and then it tells you the other amount. Explain the calculation that this program performs.

2. In Table 3.7 "Sales Data Corrected for Inflation, 2000–2005", calculate the inflation rate (that is, the percentage change in the price index) and the growth rate of sales in each year. What is the relationship between these two variables (a) when real sales are increasing and (b) when real sales are decreasing?
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