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Inflation and the Consumer Price Index Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Macroeconomic Measures of Performance Review Questions for AP Economics Exam

Main Topics: Consumer Price Index, Inflation, Is Inflation Bad, Measurement Issues

My "Latte Price Index" illustrates that a price index can be constructed to measure changes in the price of anything. Another price index, the GDP price deflator, measures the increase in the price level of items that compose GDP. But not all goods that fall into GDP are goods that the everyday household shops for. If United Airlines buys a 767 from Boeing, it falls in GDP, but the price of a new 767 doesn't exactly fall within what we might call consumer spending. We need a statistic that focuses on consumer prices.

The Consumer Price Index (CPI)

To measure the average price level of items that consumers actually buy, use the Consumer Price Index (CPI). The Bureau of Labor Statistics (BLS) selects a base year and a market basket is compiled of approximately 400 consumer goods and services bought in that year. A monthly survey is conducted in 50 urban areas around the country, and based on the results of this survey, the average prices of the items in the base year market basket is factored into the CPI. Confused yet? Let's do a simple example of a price index for a typical consumer using Table 12.5.

Price Index Current Year = 100 * (Spending Current Year)/(Spending Base Year)

2001 Price Index = 100 * (531)/(486) = 109.26

Inflation

In the above example, the price index increased from 100 in the base year to 109.26 in 2001. In other words, the average price level increased by 9.26 percent.

On a much larger scale, the official CPI is constructed and used to measure the increase in the average price level of consumer goods. The annual rate of inflation on goods consumed by the typical consumer is the percentage change in the CPI from one year to the next.

"So What Is the Difference Between the CPI and the GDP Deflator?"

This can be confusing. The difference between these two price indices lies in the content of the market basket of goods. The CPI is based upon a market basket of goods that are bought by consumers, even those goods that are produced abroad. The GDP deflator includes all items that make up domestic production. Because GDP includes more than just consumer goods, the index is a broader measure of inflation, while the CPI is a measure of inflation of only consumer goods.

Nominal and Real Income

As a consumer, I am also a worker and an income earner. Rising consumer prices hurt my ability to purchase the items that make me happy. In other words, rising prices can cause a decrease in my purchasing power. Ideally, I would like to see my income rise at a faster rate than the price of consumer goods. One way to see if this is happening is to deflate nominal income by the CPI to calculate my real income. Real income is calculated in the same way that real GDP is calculated.

  • Real Income This Year = 8(Nominal Income This Year)/CPI (in hundredths)

     

Example:

In 2002 Kelsey's nominal income is $40,000 and it increases to $41,000 in 2003. Curious about her purchasing power, she looks up the CPI in 2002 and finds that at the end of 2002 it was 181.6 and at the end of 2003 it was 185. This is compared to the base year value of 100 in 1984.

Real Income 2002 = $40,000/1.816 = $22,026

Real Income 2003 = $41,000/1.850 = $22,162

After accounting for inflation, real income increased by $136. Her nominal income increased at a rate slightly faster than the rate of inflation, and so her purchasing power has slightly increased.

Example:

What if Kelsey's wages were frozen and she did not receive that raise in 2003?

Real Income 2003 = $40,000/1.85 = $21,622,

or a $404 decrease in purchasing power

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