2.4 Price Indices and Inflation

Measuring the Price Level

A price index tracks the average price of a fixed 'basket' of goods and services over time, relative to a base year (index = 100). The Consumer Price Index (CPI) measures prices for a typical urban consumer's basket, while the GDP deflator measures prices of all goods/services produced domestically. Both help track how the overall price level changes.

Calculating Inflation

Inflation is the percentage increase in the price level over time. It's calculated as: (Price Index in Year 2 − Price Index in Year 1) / Price Index in Year 1 × 100. Deflation occurs when the price level falls, while disinflation means inflation is slowing but prices still rise.

Why CPI Isn't Perfect

CPI can overstate inflation due to substitution bias (consumers switch to cheaper goods, but the basket doesn't), quality/new product bias (fails to capture improvements), and outlet bias (ignores discount stores). The GDP deflator differs from CPI because it includes only domestically produced goods and updates its basket every year, not a fixed one.

Key terms

Price index

A measure of the average price of a fixed basket of goods/services relative to a base year (base year = 100).

CPI (Consumer Price Index)

Tracks the cost of a fixed basket of goods/services purchased by a typical urban consumer.

GDP Deflator

A price index measuring the prices of all domestically produced goods and services, using a changing basket each year.

Inflation rate formula

(Price Index Year 2 − Price Index Year 1) / Price Index Year 1 × 100.

Substitution bias

CPI overstates inflation because its fixed basket doesn't account for consumers substituting cheaper goods as relative prices change.

Try an AP-style question

What is the CPI?

1. 115
2. 130
3. 30
4. 87