Price Indexes and the Aggregate Price Level

In the spring and summer of 2011, Americans were facing sticker shock at the gas pump: the price of a gallon of regular gasoline had risen from an average of $1.61 at the end of December 2008 to close to $4. Many other prices were also up. Some prices, though, were heading down: some foods, like eggs, were coming down from a run-up in late 2010, and virtually anything involving electronics was getting cheaper as well. Yet practically everyone felt that the overall cost of living was rising. But how fast?

The aggregate price level is a measure of the overall level of prices in the economy.

Clearly, there was a need for a single number summarizing what was happening to consumer prices. Just as macroeconomists find it useful to have a single number representing the overall level of output, they also find it useful to have a single number representing 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.