Suppose that a frost in Florida destroys most of the citrus harvest. As a result, the price of an orange rises from $0.20 to $0.40, the price of a grapefruit rises from $0.60 to $1.00, and the price of a lemon 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.

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. Suppose that before the frost a typical consumer bought 200 oranges, 50 grapefruit, and 100 lemons over the course of a year, our market basket for this example.

Table 7-3 shows the pre-frost and post-frost cost of this market basket. Before the frost, it cost $95; after the frost, the same bundle 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. In addition, they perform another simplification in order to avoid having to keep track of the information that the market basket cost—for example, to avoid saying that the market basket costs $95 in 1997 dollars and $103 in 2001 dollars. They normalize the measure of the aggregate price level, which means that they set the cost of the market basket equal to 100 in the chosen base year. Working with a market basket and a base year, and after performing normalization, we obtain what is known as a price index, a normalized 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 Equation 7-2 we define the price index for citrus fruit as (cost of market basket in a given year/$95) × 100, yielding an index of 100 for the period before the frost and 184.2 after the frost. You should note that the price index for the base year always results in a price index equal to 100. This is because the price index in the base year is equal to: (cost of market basket in base year/cost of market basket in base year) × 100 = 100.

Thus, 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. For example, the consumer price index, which we’ll discuss shortly, is the most widely used measure of the aggregate price level, the overall price level of final consumer goods and services across the economy.

Price indexes are also the basis for measuring inflation. The inflation rate is the annual percent change in an official price index. The inflation rate from year 1 to year 2 is calculated using the following formula, where we assume that year 1 and year 2 are consecutive years.

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