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?
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
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
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.
Real Terms vs. Nominal Terms
Economic statistics are numbers that describe changes in the economy. They can be presented in two different ways - either as an original number or as a number that is adjusted for the cost of living, or inflation, which measures changes in the price level. Statistics that are presented to us in nominal terms show us the actual numbers before adjusting for changes in the level of prices. Statistics presented in real terms, however, show us numbers that already reflect changes in the price level and are, therefore, after inflation. Because of this adjustment, real data show us what something is worth in terms of its real purchasing power.
Here's an example: your neighbor, Bob, owns a lawn service. Bob's nominal income rises by 3% this year; the inflation rate, however, is 4%. What does that mean? That means that prices in the economy rose by more than Bob's income did. When he goes to spend his income, he'll find that he can't buy the same amount of goods and services that he could last year, even though in dollar terms his income went up. The formula for calculating this change of income in real terms is real = nominal minus inflation. This is when you're dealing with percentages. This formula works for any type of increase, whether it's income or interest rates, or GDP. So, in this example, Bob's real change in income is equal to his nominal change minus the rate of inflation, which would be 3% minus 4% = -1%. His real change in income was -1%.
A change in income expressed in real terms would be equal to the nominal change minus inflation
Looking at this scenario a different way, if Bob's nominal income rises by 3%, while his real income fell by 1%, then that means that prices in the economy rose by 4%. We can calculate this number by subtracting -1% from 3%, which give us 3% minus - 1% = 4%. We're just moving that formula around.
Let's look at one more example using interest rates instead of income. When the nominal interest rate on a bank checking account is 1% and the rate of inflation is 2%, the real interest rate would be 1% minus 2%, which would be -1%.
To summarize what we've talked about in this lesson, inflation is a sustained increase in the price level. The inflation rate is the rate at which inflation is changing, usually reported on an annual basis. The inflation rate is taken from The Consumer Price Index. The Consumer Price Index is an index measuring changes in the level of prices in the economy. It reveals the purchasing power of money, or the amount of goods and services that $1 will buy.
Statistics that are presented to us in nominal terms show us actual numbers before adjusting for changes in the level of prices, while statistics that are presented in real terms show us numbers that have been adjusted for inflation. Real data show us what something is worth in terms of its real purchasing power.
Once you've completed this lesson, you'll be able to use the Consumer Price Index to:
- Determine inflation rates
- Observe changes in purchasing power
- Understand the differences between data given in real terms and data given in nominal terms
- Calculate real income