Price Level, Inflation, and Deflation: Concepts and Measurement

Price Level, Inflation, and Deflation

Introduction to Price Level

The price level is the average level of prices and the value of money in an economy. Understanding the price level is essential for analyzing inflation and deflation, which are key macroeconomic phenomena.

• Inflation: A persistently rising price level.

• Deflation: A persistently falling price level.

Economists study the price level to:

• Measure the inflation rate or deflation rate.

• Distinguish between money values and real values of economic variables.

Why Inflation and Deflation Are Problems

Low, steady, and anticipated inflation or deflation is generally not problematic. However, unpredictable or high inflation/deflation can cause significant economic issues:

• Redistributes income between different groups (e.g., employers vs. workers, borrowers vs. lenders).

• Redistributes wealth.

• Lowers real GDP and employment.

• Diverts resources from productive activities to inflation forecasting.

From a social perspective, these effects represent a waste of resources. At its extreme, inflation can become hyperinflation, where the inflation rate is so high that money rapidly loses its value (e.g., workers are paid multiple times a day).

Measuring the Price Level: The Consumer Price Index (CPI)

The Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the average of the prices paid by urban consumers for a "fixed" basket of consumer goods and services. It is the most widely used indicator for tracking changes in the price level.

Reading the CPI Numbers

• The CPI is defined to equal 100 for the reference base period.

• Currently, the reference base period is 1982–1984 (average of these 36 months).

• Example: In May 2021, the CPI was 269.2, meaning prices were 169.2% higher than in the base period.

Constructing the CPI

Constructing the CPI involves three main stages:

• Selecting the CPI basket: Determining which goods and services are included, based on the Consumer Expenditure Survey.

• Conducting a monthly price survey: Collecting prices for the items in the basket from various locations.

• Calculating the CPI: Using the collected data to compute the index.

The CPI Basket

The CPI basket is based on data from the Consumer Expenditure Survey, which is updated infrequently. The basket reflects the spending habits of urban consumers and is periodically revised to stay current.

• Example: The 2019 Consumer Expenditure Survey data is used for the current basket.

Components of the CPI Basket

The CPI basket is divided into major components, with housing being the largest. Transportation, food, and beverages are also significant components, while all other categories account for the remaining portion.

Component	Approximate Share (%)
Housing	Largest component
Transportation and Food/Beverages	Next largest components
All other components	27%
Additional info:	Exact percentages may vary by year and survey.

The Monthly Price Survey

Each month, Bureau of Labor Statistics (BLS) employees check the prices of approximately 80,000 goods in the CPI basket across 30 metropolitan areas.

Calculating the CPI

1. Find the cost of the CPI basket at base-period prices.

2. Find the cost of the CPI basket at current-period prices.

3. Calculate the CPI for the current period.

Example Calculation:

• Suppose the CPI basket contains 10 oranges and 5 haircuts.

• Base period prices: Oranges = $1 each, Haircuts = $8 each.

• Current period prices: Oranges = $2 each, Haircuts = $10 each.

• Cost in base period: $(10 \times 1) + (5 \times 8) = $10 + $40 = $50$

• Cost in current period: $(10 \times 2) + (5 \times 10) = $20 + $50 = $70$

The CPI is calculated using the formula:

$\text{CPI} = \left( \frac{\text{Cost of basket at current-period prices}}{\text{Cost of basket at base-period prices}} \right) \times 100$

For the example above:

$\text{CPI} = \left( \frac{70}{50} \right) \times 100 = 140$

This means the CPI is 40 percent higher in the current period than in the base period.

Measuring the Inflation Rate

The main purpose of the CPI is to measure inflation. The inflation rate is the percentage change in the price level from one year to the next. The formula is:

$\text{Inflation rate} = \frac{\text{CPI (this year)} - \text{CPI (last year)}}{\text{CPI (last year)}} \times 100$

Example: If the CPI was 140 last year and 154 this year, the inflation rate is:

$\frac{154 - 140}{140} \times 100 = 10\%$

Practice Problem: Calculating CPI

Given the following data for an economy with two goods:

Year	Eggs (Qty)	Eggs (Price)	Bacon (Qty)	Bacon (Price)
2000	100	1.00	50	2.00
2001	110	1.50	45	4.00

• Q: Using 2000 as the base year, what is the CPI for 2000? For 2001?

• Additional info: To solve, calculate the cost of the basket in each year using base year quantities and prices, then apply the CPI formula.

Trends in CPI and Inflation Rate

Graphs of the CPI and inflation rate over time show periods of high inflation (e.g., 1970s) and periods of low or stable inflation. These trends are important for understanding macroeconomic stability and policy.