Tracking Inflation Quiz

PDF page 539: Moreover, the power of inflation does not affect just goods and services, but wages and income levels, too. The second-to-last row of Table 22.1 shows that the average hourly wage for a manufacturing worker increased nearly six-fold from 1970 to 2017. The average worker in 2017 is better educated and more productive than the average worker in 1970—but not six times more productive. Per capita GDP increased substantially from 1970 to 2017, but is the average person in the U.S. economy really more than eleven times better off in just 47 years? Not likely. A modern economy has millions of goods and services whose prices are continually quivering in the breezes of supply and demand. How can all of these shifts in price attribute to a single inflation rate? As with many problems in economic measurement, the conceptual answer is reasonably straightforward: Economists combine prices of a variety of goods and services into a single price level. The inflation rate is simply the percentage change in the price level. Applying the concept, however, involves some practical difficulties.

PDF page 539: beginning of 2017, $1 had about the same purchasing power in overall terms of goods and services as 18 cents did in 1972, because of the amount of inflation that has occurred over that time period.

PDF page 539: To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others. Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy. The following Work It Out feature walks you through the steps of calculating the annual rate of inflation based on a few products.

PDF page 539: To calculate the price level, economists begin with the concept of a basket of goods and services, consisting of the different items individuals, businesses, or organizations typically buy. The next step is to look at how the prices of those items change over time. In thinking about how to combine individual prices into an overall price level, many people find that their first impulse is to calculate the average of the prices. Such a calculation, however, could easily be misleading because some products matter more than others. Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy. The following Work It Out feature walks you through the steps of calculating the annual rate of inflation based on a few products.

PDF page 541: of products were much longer, and we used more realistic prices, the total quantity spent over a year might be some messy-looking number like $17,147.51 or $27,654.92. To simplify the task of interpreting the price levels for more realistic and complex baskets of goods, economists typically report the price level in each period as an index number, rather than as the dollar amount for buying the basket of goods. Economists create price indices to calculate an overall average change in relative prices over time. To convert the money spent on the basket to an index number, economists arbitrarily choose one year to be the base year, or starting point from which we measure changes in prices. The base year, by definition, has an index number equal to 100. This sounds complicated, but it is really a simple math trick. In the example above, say that we choose time period 3 as the base year. Since the total amount of spending in that year is $107, we divide that amount by itself ($107) and multiply by 100. Again, this is because the index number in the base year always has to have a value of

PDF page 540: Qty 20 1 bottle 5 - - (Pd 1) Price $3.00 $10.00 $6.00 - - (Pd 1) Amount Spent $60.00 $10.00 $30.00 $100.00 - (Pd 2) Price $3.20 $10.00 $6.50 - - (Pd 2) Amount Spent $64.00 $10.00 $32.50 $106.50 6.5% (Pd 3) Price $3.10 $10.00 $7.00 - - (Pd 3) Amount Spent $62.00 $10.00 $35.00 $107.00 0.5% (Pd 4) Price $3.50 $10.00 $7.50 - - (Pd 4) Amount Spent $70.00 $10.00 $37.50 $117.50 9.8%

PDF page 540: Qty 20 1 bottle 5 - - (Pd 1) Price $3.00 $10.00 $6.00 - - (Pd 1) Amount Spent $60.00 $10.00 $30.00 $100.00 - (Pd 2) Price $3.20 $10.00 $6.50 - - (Pd 2) Amount Spent $64.00 $10.00 $32.50 $106.50 6.5% (Pd 3) Price $3.10 $10.00 $7.00 - - (Pd 3) Amount Spent $62.00 $10.00 $35.00 $107.00 0.5% (Pd 4) Price $3.50 $10.00 $7.50 - - (Pd 4) Amount Spent $70.00 $10.00 $37.50 $117.50 9.8%

PDF page 540: while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the given basket of goods at the prices prevailing at that time.

PDF page 540: Qty 20 1 bottle 5 - - (Pd 1) Price $3.00 $10.00 $6.00 - - (Pd 1) Amount Spent $60.00 $10.00 $30.00 $100.00 - (Pd 2) Price $3.20 $10.00 $6.50 - - (Pd 2) Amount Spent $64.00 $10.00 $32.50 $106.50 6.5% (Pd 3) Price $3.10 $10.00 $7.00 - - (Pd 3) Amount Spent $62.00 $10.00 $35.00 $107.00 0.5% (Pd 4) Price $3.50 $10.00 $7.50 - - (Pd 4) Amount Spent $70.00 $10.00 $37.50 $117.50 9.8%

PDF page 542: percentage-change calculation. We calculate the precise inflation rate as the price index moves from 107 to 110 as 100 x (110 – 107) / 107 = 100 x 0.028 = 2.8%. When the base year is fairly close to 100, a quick subtraction is not a terrible shortcut to calculating the inflation rate—but when precision matters down to tenths of a percent, subtracting will not give the right answer.

PDF page 541: A word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly 3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the

PDF page 542: Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although we can use index numbers to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions that we find in other data. They transform the other data so that it is easier to work with the data. Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is arbitrary. We choose it as a starting point from which we can track changes in prices. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. However, any base year that we choose for the index numbers will result in exactly the same inflation rate. To see this in the previous example, imagine that period 1 is the base year when total spending was $100, and we assign it an index number of 100. At a glance, you can see that the index numbers would now exactly match the dollar figures, and the inflation rate in the first period would be 6.5%. Now that we see how indexes work to track inflation, the next module will show us how economists measure the cost of living.

PDF page 542: Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although we can use index numbers to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions that we find in other data. They transform the other data so that it is easier to work with the data. Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is arbitrary. We choose it as a starting point from which we can track changes in prices. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. However, any base year that we choose for the index numbers will result in exactly the same inflation rate. To see this in the previous example, imagine that period 1 is the base year when total spending was $100, and we assign it an index number of 100. At a glance, you can see that the index numbers would now exactly match the dollar figures, and the inflation rate in the first period would be 6.5%. Now that we see how indexes work to track inflation, the next module will show us how economists measure the cost of living.