4.2 Measuring the economy: Inflation

consumer price inflation

measured by the percentage increase in the cost of a representative basket of household goods and services

is it a symptom of inflation if the price of chocolate increases?

it depends - if the prices of a wide basket of G+S increases, then yes but if only the price of chocolate increases, it could be due to a crop failure or an increase in demand

consumer price index

measures the general level of prices that consumers have to pay for G+S including consumption taxes

**used to measure changes in cost of living

**based on what consumers actually buy and G+S are weighted according to fraction of household spending they account for

**excludes exports, includes imports

3 steps to calculate the rate of inflation

(1) find the cost of the basket of goods

(2) compute a price index such as the CPI
(3) use the CPI to calculate the inflation rate

CPI calculation equation

price index = basket price / basket price in base year x 100

inflation equation

(CPI2023 - CPI2022) / CPI2022 × 100

GDP deflator

also a price index but tracks change in price of all domestically produced final G+S

**instead of basket of G+S, tracks price changes of components of domestic GDP (C, I, G, X-M)

**includes exports and excludes importsGDP

GDP deflator vs CPI

CPI includes imports, excludes exports
GDP deflator includes exports, excludes imports

issues in measuring inflation

(1) substitution bias

(2) quality changes

substitution bias

some goods might rise in price faster than others during inflation —> consumers will change their consumption patterns, shifting away from goods w/ rapidly rising prices

the CPI uses a fixed basket and doesn’t account for substitutions like this so it tends to overestimate inflation

**PCE allows basket to change over time and account for changes in purchasing patterns, avoids this bias

quality changes

hard to know if price change reflects a genine quality improvement ratehr than economy-wide inflation i.e. improvements in smartphones