Measuring Inflation Measuring Inflation using a Price Index

Historical Inflation

• Germany: “hyperinflation” after World War I– Currency became worthless

• USA: Late 1970s—Oil Crisis-- 13% inflation– Called “Stagflation”

• USA: low inflation since 1985 [2.0-3.0%]

• USA speed limit: target for inflation is underunder 2.5%

Deflation

Stagflation

Low inflation 1985 - 2012

Some factors: Technology & Globalization

What is a Price Index?• A price index is used by economists to measure inflation

– This allows you convert nominal numbers => to real numbers

• A price index must choose a base year which will = 100– You use “prices” of goods from this year for all goods & services

• For AP Econ we will analyze 2 price indices:– Consumer Price Index– GDP Deflator

Calculating % Change• You buy a stock at $8 per share • It is now at $10 per share

• If a price index rises from 100 to 125?

Formula: [(Ending Price – Beginning Price) / Beginning Price] * 100

(10-8)/8 * 100 = +25%

What % gain did you make?

(125-100)/100 * 100 = +25%

CPI Index• Consumer Price Index (CPI) measures consumer inflation

– You can use any year as a base year (which = 100)

• Uses a market “basket” of goods & services– Government prices basket monthly– Compares cost of the new basket to old basket

• CPI = Current Price Value of Basket

Price Value of Basket in Base Year X 100 = CPI Index

What is in the CPI’s Basket?

17%Transportation

15%Food and beverages

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

42%Housing

6%Education and communication

CPI Index Calculation

Current Price Value of Basket

Price Value of Basket in Base Year X 100 = CPI Index

Price Value of Basket

2005 $102007 $12

($12/$10) X 100 = 120

Use 2005 as base year CPI Index = $10/$10 X 100 = 100

120 is the CPI Index for

2007

End Result:

Inflation rose 20%

(120 – 100)/100 X 100 = +20%

Worksheet

• Creating an Index

Problems with CPI

• Substitution Bias• New goods• Unmeasured quality changes• Housing Measurement

Basket must “evolve” with the market

Adjusting numbers for inflation

• Convert Babe Ruth’s wages in 1931 to 2005 dollars:

1931 Salary = $ 80,000 CPI = 15.2 1931

CPI = 195 2005

19515.2

X $80,000 = 1,026,316 (2005 dollars)

CPI Index (2005)

Base Year Index (1931)

X Old Dollar Value = 2005 dollars

Practice Test