Tracking Inflation Quiz

PDF page 201: 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 8.1 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 201: 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 201: 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 201: 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 201: Consider the simple basket of goods with only three items, represented in Table 8.2. Say that in any given month, a college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. The table provides prices for these items over four years through each time period (Pd). Prices of some goods in the basket may rise while others fall. In this example, the price of aspirin does not change over the four years, while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the

PDF page 201: Consider the simple basket of goods with only three items, represented in Table 8.2. Say that in any given month, a college student spends money on 20 hamburgers, one bottle of aspirin, and five movies. The table provides prices for these items over four years through each time period (Pd). Prices of some goods in the basket may rise while others fall. In this example, the price of aspirin does not change over the four years, while movies increase in price and hamburgers bounce up and down. The table shows the cost of buying the

PDF page 202: 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 202: 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 202: ⎝Level in new year – Level in previous year ⎠ x 100 = Percentage change Level in previous year

PDF page 202: 107 This calculation of the change in the total cost of purchasing a basket of goods accounts for how much a student spends on each good. Hamburgers are the lowest-priced good in this example, and aspirin is the highest-priced. If an individual buys a greater quantity of a low-price good, then it makes sense that changes in the price of that good should have a larger impact on the buying power of that person’s money. The larger impact of hamburgers shows up in the “amount spent” row, where, in all time periods, hamburgers are the largest item within the amount spent row.

PDF page 203: 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 203: 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 203: 1.07 93.4 107 100 – 99.5 Period 3 $107 = 100.0