In the summer of 2008, Americans were facing sticker shock at the gas pump: the price of a gallon of regular gasoline had risen from about $3 in late 2007 to more than $4 in most places. Many other prices were also up. Some prices, though, were heading down: the prices of some foods, like eggs, were coming down from a run-up earlier in the year, and virtually anything involving electronics was also getting cheaper. Yet practically everyone felt that the overall cost of living seemed to be rising. But how fast?

Clearly there was a need for a single number that would summarize what was happening to consumer prices. Just as macroeconomists find it useful to have a single number to represent the overall level of output, they also find it useful to have a single number to represent the overall level of prices: the aggregate price level. Yet a huge variety of goods and services are produced and consumed in the economy. How can we summarize the prices of all these goods and services with a single number? The answer lies in the concept of a price index—a concept best introduced with an example.

Suppose that a frost in Florida destroys most of the citrus harvest. As a result, the price of oranges rises from $0.20 each to $0.40 each, the price of grapefruit rises from $0.60 to $1.00, and the price of lemons rises from $0.25 to $0.45. How much has the price of citrus fruit increased?

One way to answer that question is to state three numbers—the changes in prices for oranges, grapefruit, and lemons. But this is a very cumbersome method. Rather than having to recite three numbers in an effort to track changes in the prices of citrus fruit, we would prefer to have some kind of overall measure of the average price change.

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To measure average price changes for consumer goods and services, economists track changes in the cost of a typical consumer’s consumption bundle—the typical basket of goods and services purchased before the price changes. A hypothetical consumption bundle, used to measure changes in the overall price level, is known as a market basket. For our market basket in this example we will suppose that, before the frost, a typical consumer bought 200 oranges, 50 grapefruit, and 100 lemons over the course of a year.

Table 15.1 shows the pre-frost and post-frost costs of this market basket. Before the frost, it cost $95; after the frost, the same basket of goods cost $175. Since $175/$95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost basket, a cost increase of 84.2%. In this example, the average price of citrus fruit has increased 84.2% since the base year as a result of the frost, where the base year is the initial year used in the measurement of the price change.

Economists use the same method to measure changes in the overall price level: they track changes in the cost of buying a given market basket. Working with a market basket and a base year, we obtain what is known as a price index, a measure of the overall price level. It is always cited along with the year for which the aggregate price level is being measured and the base year. A price index can be calculated using the following formula:

In our example, the citrus fruit market basket cost $95 in the base year, the year before the frost. So by applying Equation 15-1, we define the price index for citrus fruit as (cost of market basket in the current year/$95) × 100, yielding an index of 100 for the period before the frost and 184.2 after the frost. You should note that applying Equation 15-1 to calculate the price index for the base year always results in a price index of (cost of market basket in base year/cost of market basket in base year) × 100 = 100. Choosing a price index formula that always normalizes the index value to 100 in the base year avoids the need to keep track of the cost of the market basket, for example, $95, in such and such a year.

The price index makes it clear that the average price of citrus has risen 84.2% as a consequence of the frost. Because of its simplicity and intuitive appeal, the method we’ve just described is used to calculate a variety of price indexes to track average price changes among a variety of different groups of goods and services. Examples include the consumer price index and the producer price index, which we’ll discuss shortly. Price indexes are also the basis for measuring inflation. The price level mentioned in the inflation rate formula in Module 14 is simply a price index value, and the inflation rate is determined as the annual percentage change in an official price index. The inflation rate from year 1 to year 2 is thus calculated using the following formula, with year 1 and year 2 being consecutive years.

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Typically, a news report that cites “the inflation rate” is referring to the annual percentage change in the consumer price index.

The most widely used measure of the overall price level in the United States is the consumer price index (often referred to simply as the CPI), which is intended to show how the cost of all purchases by a typical urban family has changed over time. It is calculated by surveying market prices for a market basket that is constructed to represent the consumption of a typical family of four living in a typical American city. Rather than having a single base year, the CPI currently has a base period of 1982–1984.

The market basket used to calculate the CPI is far more complex than the three-fruit market basket we described above. In fact, to calculate the CPI, the Bureau of Labor Statistics sends its employees out to survey supermarkets, gas stations, hardware stores, and so on—some 23,000 retail outlets in 87 cities. Every month it tabulates about 80,000 prices, on everything from romaine lettuce to a medical checkup. Figure 15.1 shows the weight of major categories in the consumer price index as of December 2012. For example, motor fuel, mainly gasoline, accounted for 5% of the CPI in December 2012.

Figure 15.2 shows how the CPI has changed since measurement began in 1913. Since 1940, the CPI has risen steadily, although its annual percentage increases in recent years have been much smaller than those of the 1970s and early 1980s. A logarithmic scale is used so that equal percentage changes in the CPI appear the same.

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Some economists believe that the consumer price index systematically overstates the actual rate of inflation. Why? Suppose the price of everything in the market basket used to calculate the CPI increased by 10% over the past year. The typical consumer might not need to spend 10% more this year to be as well off as last year, for three reasons.

First, each item remains in the studied market basket for four years. Yet consumers frequently alter the mix of goods and services they buy, reducing purchases of products that have become relatively more expensive and increasing purchases of products that have become relatively cheaper. For example, suppose that the price of hamburgers suddenly doubled. Americans currently eat a lot of hamburgers, but in the face of such a price rise many of them would switch to chicken sandwiches, pizza, or other substitutes whose prices hadn’t increased as much. As a result, a price index based on a market basket with a lot of hamburgers in it would overstate the true rise in the cost of living.

The second reason arises from product improvements. It’s likely that over the years your favorite toothpaste, laundry detergent, and snack foods have both increased in price and come out in “new and improved” versions. If what you’re getting is really better than before, you aren’t paying more for the same product. Rather, you’re paying more and getting more. The Bureau of Labor Statistics does its best to make adjustments for changes in product quality, but it is hard to measure the extent to which consumers are getting more as opposed to simply paying more.

The third reason that inflation rate estimates may be misleading is innovation. Every new year brings new items, such as new electronic gadgets, new smartphone apps, new health care solutions, and new clothing options. By widening the range of consumer choice, innovation makes a given amount of money worth more. That is, innovation creates benefits similar to those of a fall in consumer prices. For all of these reasons, changes in the CPI may overstate changes in the cost of maintaining a particular standard of living. However, with more frequent updates of the market basket, among other tweaks in its methods, the Bureau of Labor Statistics has improved the accuracy of the CPI in recent years. And, despite some remaining controversy, the CPI remains the basis for most estimates of inflation.

The United States is not the only country that calculates a consumer price index. In fact, nearly every country calculates one. As you might expect, the market baskets that make up these indexes differ quite a lot from country to country. In poor countries, where people must spend a high proportion of their income just to feed themselves, food makes up a large share of the price index. Among high-income countries, differences in consumption patterns lead to differences in the price indexes: the Japanese price index puts a larger weight on raw fish and a smaller weight on beef than ours does, and the French price index puts a larger weight on wine.

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There are two other price measures that are also widely used to track economy-wide price changes. One is the producer price index (or PPI, which used to be known as the wholesale price index). As its name suggests, the producer price index measures the cost of a typical basket of goods and services—containing raw commodities such as steel, electricity, coal, and so on—purchased by producers. Because commodity producers are relatively quick to raise prices when they perceive a change in overall demand for their goods, the PPI often responds to inflationary or deflationary pressures more quickly than the CPI. As a result, the PPI is often regarded as an “early warning signal” of changes in the inflation rate.

The other widely used price measure is the GDP deflator; it isn’t exactly a price index, although it serves the same purpose. Recall how we distinguished between nominal GDP (GDP in current prices) and real GDP (GDP calculated using the prices of a base year). The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year. Since the Bureau of Economic Analysis—the source of the GDP deflator—calculates real GDP using a base year of 2005, the nominal GDP and the real GDP for 2005 are the same. This makes the GDP deflator for 2005 equal to 100. For this reason, later in this book you will see measures of the aggregate price level with the designation “GDP Deflator, 2005 = 100.” And in many cases you will see real GDP measured in 2005 dollars. Inflation raises nominal GDP but not real GDP, causing the GDP deflator to rise. If nominal GDP doubles but real GDP does not change, the GDP deflator indicates that the aggregate price level has doubled.

Perhaps the most important point about the different inflation rates generated by these three measures of prices is that they usually move closely together (although the producer price index tends to fluctuate more than either of the other two measures). Figure 15.3 shows the annual percentage changes in the three indexes since 1930. By all three measures, the U.S. economy experienced deflation during the early years of the Great Depression, inflation during World War II, accelerating inflation during the 1970s, and a return to relative price stability in the 1990s. Notice, by the way, the dramatic ups and downs in producer prices from 2000 to 2012. This reflects large swings in energy and food prices, which play a much bigger role in the PPI than they do in either the CPI or the GDP deflator.

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