CALCULATING INFLATION:

PRICE CHANGE, CPI, AND THE GDP DEFLATOR

INFLATION FOR A SINGLE GOOD

Inflation is the percent change in

prices.

Therefore, in its simplest form,

inflation can be calculated as:• (Price in Year 2 - Price in Base

Year) x 100 Price in Base Year

MEASURING AGGREGATE PRICE

CHANGES

How do you measure overall

inflation for an entire economy’s

worth of goods?

Two most common methods: • the Consumer Price Index (CPI) and• The GDP Deflator

THE CONSUMER PRICE INDEX (CPI)

Combines the prices of a bundle of

goods and services.

Based on a market basket of more

than 200 categories of goods and

services weighted according to how

much the average consumer spends on

them.

CONSUMER PRICE INDEX

CPI= Cost of market basket in current-year prices x 100

Cost of market basket in base-year prices

DOWNSIDE TO USING CPI

Substitution bias –• As the price of a good rises, people will buy

more of the good’s substitute. With more of the substitute being purchased, the CPI will account for the substitute and reflect no overall change in the price level of the economy while the original good did in fact change in price.

DOWNSIDE TO USING CPI

Introduction of new goods –

• When new goods are introduced to an economy, they typically have a short-term high price. Over time, the price decreases to an equilibrium price. The CPI often accounts for the good at its high price, consequently creating a higher price level than what is accurate.

DOWNSIDE TO USING CPI

Improvement in quality –

• The CPI does not account for changes in quality of goods and services. When incomes are high, people will buy more luxury goods while non-luxury versions of the same goods are available. The CPI will increase as average prices of the goods increase because more people buy the luxury version. This leads to an increase in the CPI when prices may not have necessarily changed at all.

GDP DEFLATOR

GDP deflator measures price

changes in current year compared

to those in a base year FOR ALL

GOODS AND SERVICES produced

within the economy.

GDP DEFLATOR

To Calculate:

•Nominal GDP x 100

Real GDP

CPI VS. GDP DEFLATOR

CPI GDP Deflator

Is calculated based on a FIXED BASKET of goods

and services

The data is not based on a basket of goods but on the economy as a whole

Much simpler for Economists to calculate and the data is available much sooner than GDP

Deflator data.

GDP Deflator is not affected by changes in

tastes or the introduction of new products in the

market

USING THE CPI AND GDP DEFLATOR TO CALCULATE

INFLATION

Inflation rate =

Price Index year 2 – Price Index year 1

Price Index year 1

USING PRICE IN DICES T O CALCULATE REAL GDP

Price Index =

Therefore…

Real GDP =

ASSIGNMENT

Complete page 67-69 of the packet you

received on Thursday

Complete problems 3, 7, and 10 on pages 151-

153 (due Wednesday)

Read Modules 12 and 13 for Wednesday.

Quiz Wednesday on calculating GDP and

Inflation.