Economics Online Tutor
The subject of inflation is very important in the study of economics.
Inflation affects many aspects of the economy, and involves many different
concepts. This section deals with several of these concepts.
Because of the magnitude of the subject matter, the subject of inflation is
divided into several pages. It starts on this page, with a discussion of the
definition of inflation, plus a mention of different price indexes, including
a note about the reliability of the official price indexes.
For other topics relating to inflation, use the links on the left side of this
page. In addition, the subject of inflation is mentioned in several other,
related sections of this site.
The discussion begins here:
You do not need to possess a degree in economics in order to understand
many of the effects of inflation. Almost everybody has had to learn to deal
with the consequences of inflation at some point in their lives. But
misconceptions still exist. It would be helpful to know what the inflation
rate means, as well as possible causes and solutions.
The definition of inflation would be a good starting point:
Inflation: A sustained rise in the average level of prices.
Not all prices change at the same time or by the same amount. The
inflation rate measures average, not individual, price changes.
Inflation represents a decline in the purchasing power of the currency. As
prices rise, the same nominal value of the currency will be worth less in
terms of the amount of goods and services that it can be used to
purchase. An alternative definition of inflation would be:
Inflation: A sustained decline in the value of the
|WHAT IS THE CORRECT PLURAL OF THE WORD INDEX?
DURING THE TIME I WAS GROWING UP, I WAS TAUGHT THAT THE
PLURAL IS INDICES. HOWEVER, MY DICTIONARY LISTS INDEXES AS
THE PREFERRED PLURAL, ALTHOUGH INDICES IS AN ACCEPTABLE
ALTERNATIVE. FOR THIS SITE, I AM USING THE PREFERRED
PLURAL OF INDEXES.
It would be impossible to track the price changes and quantities sold for every good and service in a
complex economy. Besides, different price indexes are used to measure the degree that inflation affects
different groups of people. Therefore, only prices and quantities for something considered to be a
"typical" bundle of goods are included in the calculations. The inflation rate measures average price
changes over time. This is done by assigning a number, called a price index, to the average price level
for each time period (usually one year). A change in the price index from one year to another would
indicate the level of inflation.
One price index commonly used is the GDP Deflator, or the GDP Price Index. That index is covered in the
section of this site entitled "Nominal and Real Values". Two other common price indexes will be
mentioned here: The Consumer Price Index (CPI), and the Producer Price Index (PPI).
Consumer Price Index (CPI)
The CPI measures the prices of a "typical" bundle of goods that an "average" household purchases.
Cost of living adjustments (COLAs) for people on fixed incomes, as well as many wage earners, are tied to
The CPI is a measurement that is far from perfect. For one thing, the economy is not made up of only
"average" households that purchase a "typical" bundle of goods. Differences are especially noticeable
between different demographic groups, such as age groups. In addition, price changes alone can cause
changes in what actual bundle of goods that consumers purchase. For example, if some goods in the
bundle increase in price while others decrease in price, the law of demand says that consumers will tend
to buy fewer of the goods with rising prices and more of the goods with falling prices, relative to each
other, over time. The CPI does not measure this change in the way households decide what to purchase.
Instead, the CPI maintains a constant bundle of goods over time. This gives the official CPI an upward
bias: it overstates the value assigned to goods with prices that are increasing at a faster rate.
Another source of upward bias in the CPI is the quality of the goods being measured. Over time, the
quality of the same type of goods tends to increase. New technology, new features, etc. But the CPI
considers goods to be the same over time. When consumers are paying a higher price, part of the price
change may be due to an increase in quality, not an increase in the price level. The CPI does not factor
this into the calculations.
Here is a link that you might find handy for calculating inflation:
CPI INFLATION CALCULATOR PROVIDED BY THE BUREAU OF LABOR STATISTICS
What is the difference between CPI and Chained CPI?
Click here for an explanation of chained CPI and how it differs from CPI
Producer Price Index (PPI)
Formerly known as the Wholesale Price Index (WPI), the PPI measures the prices received by producers.
This is considered to be a leading economic indicator, because it measures price changes at an earlier
stage than CPI does. If the PPI increases, it can be expected that an increase in the CPI will soon follow.
FORMULAS USED FOR MEASURING INFLATION
PRICE INDEX FORMULA:
PRICE INDEX (YEAR X) = 100 x (SUM OF (YEAR X PRICE x BASE
YEAR QUANTITY) DIVIDED BY SUM OF (BASE YEAR PRICE x BASE
INFLATION RATE FORMULA:
INFLATION RATE = (PRICE INDEX YEAR Y MINUS PRICE INDEX YEAR
X) DIVIDED BY PRICE INDEX YEAR X
AN ALTERNATIVE FORMULA:
INFLATION RATE = (100 x (PRICE INDEX YEAR Y DIVIDED BY PRICE
INDEX YEAR X)) MINUS 100
ANOTHER ALTERNATIVE FORMULA:
INFLATION RATE = (TOTAL VALUE OF BUNDLE YEAR Y MINUS
TOTAL VALUE OF BUNDLE YEAR X) DIVIDED BY TOTAL VALUE OF
BUNDLE YEAR X
TO SEE HOW THESE FORMULAS WORK, GO TO THE NEXT PAGE,
TITLED "CALCULATING PRICE INDEXES AND INFLATION:
FORMULAS AND EXAMPLES"
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