Price Indices and Inflation

inflation

A sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar.

inflation rate

The pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next.

deflation

A sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.

disinflation

A slowing of the rate of inflation; for example, if the rate of inflation is 5% in 2016 and 3% in 2017, there is still inflation in 2017; prices are just not rising as fast as they were before.

aggregate price level

A single number that summarizes all prices in an economy; price indices are frequently used to represent the aggregate price level.

price index

A measure that calculates the changing cost of purchasing a particular combination of goods (called a 'market basket') each year; the consumer price index and the producer price index are examples.

consumer price index (CPI)

An index that calculates the cost of a market basket of goods purchased by a typical family that lives in an urban area; the purpose of the CPI is to track changes in the cost of living over time.

market basket

The combination of goods that are used to calculate a price index; the goods stay the same from year to year.

base year

A reference year to which variables are compared; for example, the current CPI in the United States uses 1983 as its base year.

real variables

Variables adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP).

nominal variables

Variables such as wages, income, or interest that have not been adjusted for the rate of inflation.

purchasing power

What can actually be bought with money; reflects the quantity of goods purchased at a given price.

real interest rate

The interest rate earned that reflects the actual purchasing power of that interest; it accounts for inflation.

CPI formula

CPI = (Current cost of basket in current year) / (Cost of basket in base year) x 100.

Inflation rate calculation

Inflation Rate (%) = ((CPI this year - CPI last year) / CPI last year) x 100.