1.4 Module 16: Measuring Inflation

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The Aggregate Price Level

In the fall of 2012, Americans were facing sticker shock at the gas pump: the price of a gallon of regular gasoline had risen from about $3.40 that spring, to $3.90—an increase of 15%. For consumers, that meant paying $5.00 more for every 10 gallons of gas purchased. Food prices were also up, rising about 3% per year for each of the last five years. Some prices, though, were falling: housing prices had dropped dramatically since 2008, and most electronics were getting cheaper. Yet practically everyone felt that the overall cost of living seemed to be rising. But how fast?

Clearly there is a need for a single number summarizing what happens 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.

Market Baskets and Price Indexes

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.

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.

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Table 16-1 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 16-1, 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 16-1 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 the previous module is simply a price index value, and the inflation rate is determined as the annual percent 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.

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

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. The base period for the index is currently 1982–1984, that is, the index is calculated so that the average of consumer prices in 1982–1984 is 100.

The CPI measures the changes in price level for a representative basket of goods and services purchased by a typical household.

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The market basket used to calculate the CPI is far more complex than the three-fruit market basket we just described. 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 movie rentals. Figure 16-1 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.

This chart shows the percentage shares of major types of spending in the CPI as of December 2012. Housing, food, transportation, and motor fuel made up about 73% of the CPI market basket.

Source: Bureau of Labor Statistics.

Every few years the Bureau of Labor Statistics updates the market basket used to calculate the CPI to reflect changes in the monthly purchases of the typical urban family of four. For example, food and beverages are now a smaller percentage of the basket, having gone from 21% in 1978 to 15% in 2012. In addition, as technology has changed over time, new goods are added to the basket, such as smart phones and tablets like the iPad.

Figure 16-2 shows how the CPI has changed since measurement began in 1913. Since 1940, the CPI has risen steadily, although the annual percent increases in recent years have been much smaller than those of the 1970s and early 1980s. A logarithmic scale is used so that equal percent changes in the CPI appear the same.

Since 1940, the CPI has risen steadily. But the annual percent increases in recent years have been much smaller than those of the 1970s and early 1980s. (The vertical axis is measured on a logarithmic scale so that equal percent changes in the CPI have the same slope.)

Source: Bureau of Labor Statistics.

Because consumption patterns vary, market baskets vary dramatically between rich and poor counties and then from country to country.

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Nearly every country in the world calculates a consumer price index. 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.

Other Price Measures

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 equal to 100 times the ratio of nominal GDP for that year to real GDP for that year expressed in prices of a selected base year. Since real GDP is currently expressed in 2005 dollars, the GDP deflator for 2005 is equal to 100. If nominal GDP doubles but real GDP does not change, the GDP deflator indicates that the aggregate price level 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 16-3 shows the annual percent 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.

As the figure shows, the three different measures of inflation, the PPI (orange), the CPI (green), and the GDP deflator (purple), usually move closely together. Each reveals a drastic acceleration of inflation during the 1970s and a return to relative price stability in the 1990s.

Sources: Bureau of Labor Statistics; Bureau of Economic Analysis.

Notice, by the way, the dramatic ups and downs in producer prices from 2000 through 2012 shown in Figure 16-3. This roller-coaster ride in prices reflects large changes 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.

INDEXING TO THE CPI

Although GDP is a very important number for shaping economic policy, official statistics on GDP don’t have a direct effect on people’s lives. The CPI, by contrast, has a direct and immediate impact on millions of Americans. The reason is that many payments are tied, or “indexed,” to the CPI—the amount paid rises or falls when the CPI rises or falls.

The practice of indexing payments to consumer prices goes back to the dawn of the United States as a nation. In 1780 the Massachusetts State Legislature recognized that the pay of its soldiers fighting the British needed to be increased because of inflation that occurred during the Revolutionary War. The legislature adopted a formula that made a soldier’s pay proportional to the cost of a market basket consisting of 5 bushels of corn, pounds of beef, 10 pounds of sheep’s wool, and 16 pounds of sole leather.

Today, over 56 million people, most of them old or disabled, receive checks from Social Security, a national retirement program that accounts for almost a quarter of current total federal spending—more than the defense budget. The amount of an individual’s check is determined by a formula that reflects his or her previous payments into the system as well as other factors.

The Bureau of Labor Statistics calculates the CPI by collecting and interpreting price and consumption data.

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In addition, all Social Security payments are adjusted each year to offset any increase in consumer prices over the previous year. The CPI is used to calculate the official estimate of the inflation rate used to adjust these payments yearly. So every percentage point added to the official estimate of the rate of inflation adds 1% to the checks received by tens of millions of individuals.

Other government payments are also indexed to the CPI. In addition, income tax brackets, the bands of income levels that determine a taxpayer’s income tax rate, are indexed to the CPI. (An individual in a higher income bracket pays a higher income tax rate in a progressive tax system like ours.) Indexing also extends to the private sector, where many private contracts, including some wage settlements, contain cost-of-living allowances (called COLAs) that adjust payments in proportion to changes in the CPI.

Because the CPI plays such an important and direct role in people’s lives, it’s a politically sensitive number. The Bureau of Labor Statistics, which calculates the CPI, takes great care in collecting and interpreting price and consumption data. It uses a complex method in which households are surveyed to determine what they buy and where they shop, and a carefully selected sample of stores are surveyed to get representative prices.

Module 16 Review

Check Your Understanding

The accompanying table contains the values of two price indexes for the years 2010, 2011, and 2012: the GDP deflator and the CPI. For each price index, calculate the inflation rate from 2010 to 2011 and from 2011 to 2012.