CHAPTER 7
THE PRICE LEVEL AND INFLATION
MASTERY GOALS
The objectives of this chapter are to:
1. Describe how index numbers are calculated.
2. Discuss how the Consumer Price Index (CPI) is compiled and how it is used.
3. Describe what the inflation rate measures.
4. Define deflation.
5. Explain why it is important to translate nominal variables into real variables.
6. Discuss why the GDP price index, rather than the CPI, is used to translate nominal
GDP into real GDP.
7. Describe the costs associated with inflation, and explain why inflation—by itself—
does not erode the average real income in the economy.
8. Explain why inflation can redistribute purchasing power when it is not correctly
anticipated.
9. Explain why the CPI overstates the inflation rate, and why this is a problem.
10. Describe the steps the Bureau of Labor Statistics (BLS) has taken to make the CPI
more accurate.
11. Describe the problems inherent in using the CPI to measure the cost of living.
12. (Appendix) Understand how to mathematically calculate the CPI.
THE CHAPTER IN A NUTSHELL
The value of the dollar—its purchasing power—changes from year to year as the price level
changes. Most measures of the price level are reported as an index. Index numbers compress and
simplify information, so that we can see how things are changing at a glance. Two major price
indices are the Consumer Price Index (CPI) and the GDP price index.
The CPI tracks the prices paid by the typical consumer. It excludes goods and services not
directly purchased by consumers, such as raw materials, wholesale goods and machinery that
firms buy, and goods and services purchased by the government. On the other hand, it includes
the purchases of some things, like used cars and imported goods, that are not included in GDP.
The CPI’s approach is to look at a typical consumer’s “basket of goods,” and compare the
basket’s cost in the current period with the cost in some base period.
While a price index tells us the overall price level, the inflation rate tells us how fast the price
level is changing, in percentage terms. When the price level is rising, the inflation rate is
positive. Deflation occurs when the price level is falling.
The CPI is an important measure in the economy. It is used to index payments, as a policy target,
and to translate nominal variables into real variables. It is important to translate nominal
variables, such as wages, into real variables when we study the macroeconomy, because we care
not about the number of dollars we are counting, but the purchasing power those dollars
represent.
The GDP price index, rather than the CPI index, is used to translate nominal GDP into real GDP.
The GDP price index measures the prices of all final goods and services produced in the United
States, while the CPI measures the prices of all goods and services bought only by households.
Inflation is costly. The common idea that inflation imposes a cost on society by decreasing the
average level of income in the economy is incorrect. It can, however, redistribute purchasing
power from one group to another, to the extent that inflationary expectations are inaccurate. (If
inflation is fully anticipated, and if there are no restrictions on contracts, then inflation will not
redistribute purchasing power.) Also, when people must spend time and other resources coping
with inflation, they sacrifice the other goods and services those resources could have produced.
Several conceptual problems and resource limitations make the CPI fall short of the ideal
measure of inflation. Although the BLS has partially fixed the problem, the CPI still suffers from
substitution bias. That is, categories of goods whose prices are rising most rapidly tend to be
given exaggerated importance in the CPI, and categories of goods whose prices are rising most
slowly tend to be given too little importance in the CPI.
The CPI excludes new products that tend to drop in price when they first come on the market.
When included, the CPI regards them as entirely separate from existing goods and services,
instead of recognizing that the lower the cost of achieving a given standard of living. The result
is an overestimate of the inflation rate.
The CPI also fails to recognize that prices may rise because of quality improvements, not
because the cost of living has risen. Finally, the CPI omits reductions in the prices people pay
from more frequent shopping at discount stores and so overstates the inflation rate. These
problems all lead to overstatement of the inflation rate.
The Using the Theory Section reviews issues involved in indexing Social Security benefits. An
appendix to this chapter demonstrates how the BLS calculates the CPI.
Price level: The average level of prices in the economy.
Index: A series of numbers used to track a variable’s rise or fall over time.
Consumer price index: An index of the cost, through time, of a market basket of goods
purchased by a typical household.
Inflation rate: The percentage change in the price level from one period to the next.
Deflation: A decrease in the price level from one period to the next.
Indexed payment: A payment that is periodically adjusted in proportion with a price index.
GDP price index: An index of the price level for all final goods and services included in
GDP.
Nominal interest rate: The annual percent increase in a lender’s dollars from making a
loan.
Real interest rate: The annual percent increase in a lender’s purchasing power from making
a loan.
TEACHING TIPS
1 Hyperinflation stories are effective teaching tools because they emphasize the costs of
inflation. Students are frequently amazed by the phenomenon of hyperinflation, and listen
attentively to examples. See Robert Frank’s “Impoverished Bulgaria Is Ready for Reform
—Seven Years Too Late,” The Wall Street Journal, February 28, 1997, p. A1, for a story
about Bulgaria’s recent experiences with runaway inflation, or Richard Sanders’
“Economic Crisis in Venezuela Is Seen Growing; Inflation May Top 100%,” The Wall
Street Journal, December 12, 1994, for Venezuela’s experiences.
2 Find the latest CPI figures at www.bls.gov/cpi or at http://research.stlouisfed.org/fred2/
3 GDP price index figures are available at http://research.stlouisfed.org/fred2/categories/18 .
4 Have students browse through the answers to frequently asked questions about the CPI at
http://www.bls.gov/cpi/cpifaq.htm . Topics of particular interest include:
#2 How is the CPI used?
#3 Whose buying habits does the CPI reflect?
#6 How is the CPI market basket determined?
#7 What goods and services does the CPI cover?
#11 How do I read or interpret an index?
#13 Which index is the “Official CPI” reported in the media?
13. The CPI does not overstate inflation to the degree that it used to, due to a revision that
occurred in January 1999. For information about the revision, go to
http://www.bls.gov/cpi/ and, under the heading “General Overview,” click on
“Measurement Issues,” then click on “BLS to Use Geometric Mean Formula for
Calculating Most Basic Indexes Starting in January 1999.”
DISCUSSION STARTERS
1 The federal minimum wage has been set at $7.25 since July 24, 2009. Have students use
the CPI to see how the purchasing power of this wage rate has changed over time.
14. George Will describes the “vast constituency” that prospers from the inaccuracy of the
CPI, in “Inflation Inflated,” Newsweek, September 30, 1996, p. 92. Discuss the political
difficulties with fixing the CPI when special interest groups are involved.
15. See “Measurement Issues in the Consumer Price Index” at
http://www.bls.gov/cpi/cpigm697.htm
. Scroll down to Appendix C for examples of
new car reliability/durability quality adjustments. New cars are better than they used to
be because of improved corrosion protection, increased warranties, and the introduction
of things like spark plugs that last longer (100,000-mile life), clear coat paint,
rust-resistant fuel injection systems, and Dextron III transmission fluid (100,000-mile
life). These improvements have increased both the value of and the price of new cars.
Discuss why the CPI should be adjusted for these reliability/durability improvements.