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Consumer Price Index: Measuring the Cost of Living and Inflation

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  • 0:05 Why Do Prices Rise?
  • 2:35 Inflation and Deflation
  • 3:22 Consumer Price Index
  • 4:57 Real Terms vs. Nominal Terms
  • 7:30 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, you'll learn what the Consumer Price Index is and how it measures changes in the level of prices in an economy. You'll also learn about the important economic concepts of inflation and deflation. Why do prices always seem to be going up?

Introduction

In the economy, there is a circular flow of money, factors of production, and goods and services. For example, when Dave works for Mandy's Cake Walk as a cake decorator, he earns an income he can spend on goods and services. During the year, Dave spends his income on a wide variety of products and services. When Dave goes to the store, he takes $100 with him, and he buys a regular basket of items that he needs throughout the year. Let's say he buys eggs, milk, cereal, bread, a pound of ground beef, celery, and orange juice. He also buys gas for his car, pays a utility bill, and makes a monthly payment for shelter throughout the year. This year, Dave buys a used car, takes a vacation by airplane, and also goes to the doctor. All of these expenses are incorporated into the Consumer Price Index each year and measured across the entire economy.

There is a circular flow of money, where people work, earn income and purchase goods and services
Money Cycle

Why is this important? Because next year, when Dave goes to the store and spends the same $100, he notices that his $100 does not buy the same amount of stuff. This is because the prices of goods and services tend to go up over time. Dave's cost of living has increased, not only when he goes to the store, but also when it costs more to fill up his gas tank and when it costs more to take a vacation. Inflation is one of the most important concepts you can possibly understand in macroeconomics, and it affects each and every one of us.

Why Do Prices Rise?

Why do prices rise? One reason is changes in supply and demand. For example, when demand for products and services increases, suppliers will raise their prices in response. Likewise, when the Organization of Petroleum Exporting Countries (OPEC) decides to reduce the supply of oil, then, if nothing else changes, the price of oil (and therefore gasoline) will rise. Another reason that prices tend to rise is because the supply of money in an economy increases. This makes the value of each dollar worth less. The effect of a falling dollar is rising prices.

Inflation and Deflation

Let's take a look at inflation through the eyes of an economist. Inflation is a sustained increase in the average level of prices in the economy. The opposite of inflation is deflation, which is a sustained decrease in the level of prices in an economy. The inflation rate is the rate at which prices are increasing, usually on an annual basis. The inflation rate is a widely watched report released by the Bureau of Labor Statistics. In the 1970s, the U.S. experienced a dramatic increase in the rate of inflation that led to a major economic challenge, especially for business owners, who encountered extremely high rates on bank loans.

Economists measure inflation, or changes in the level of prices, using a price index. The Consumer Price Index is an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation in an economy. The Consumer Price Index reveals to us the capacity of our money to buy goods and services, which we call purchasing power. Purchasing power represents the amount of goods and services that $1 will buy. When prices go up that means the purchasing power of money has gone down.

The consumer price index compares a particular year to a base year and determines the inflation rate
Price Index

Here's an example. An index is a number that starts at 100 in a certain year, which we call the base year. It changes over time in comparison with the base year and can be easily converted into a percentage since the base year starts at 100. For example, if the Consumer Price Index is said to start at 100 in the year 2010 and then the index increases to 103 in 2011, we can quickly calculate that prices in our economy have risen by 3 divided by 100, which is 3%. That means the inflation rate is 3% and that $1 will buy 3% fewer goods and services than it did at the end of the previous year.

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