Measuring Inflation

Inflation is an increase in the general level of prices, or, alternatively, it is a decrease in the value of money. To say that prices have gone up means that a given number of dollars buys less, or that the value of money has gone down. An economy without money, using only barter, could have no inflation. The opposite of inflation is deflation, a decrease in the general level of prices or a rise in the value of money.

People consider the rate of inflation important because it affects their planning. They will spend money differently if they expect a 20% annual price increase than if they expect stable prices. For example, if prices are declining, holding inventories is expensive, and sellers will try to minimize inventories. The price at which people borrow and lend funds will also depend heavily on what they expect to happen to prices.

The Department of Labor provides a simple, common-sense way to measure inflation, the Consumer Price Index or CPI. The Labor Department has surveyed the purchasing patterns of consumers to determine a group of about 400 items that buyers typically use. This shopping list of 400 items makes up a "market basket." Each month a host of price surveyors checks on the prices of these items in cities across America. These results are then used to compute what the market basket costs compared to what it cost in a base period.

A numerical example makes this procedure clear. Suppose a representative market basket of weekly expenditures of teenagers is three hamburgers, eight colas, and one gallon of gasoline. (Of course this is much too small a basket to be realistic, but this example illustrates the procedure.) With the prices of year 1 shown in the table below, the cost of the market basket is $5.00. In year 2 two prices have risen and one has declined. Yet one can say that on the whole the price level has risen because the cost of the market basket has risen to $5.50. This is an increase of 10% (50/500 = 10%). From year 2 to year 3 prices change again, and the cost of the market basket goes up by another $.50. In year 3 the price level is 20% higher than it was in year 1 ([600 - 500]/500 = 20%), and 9.1% higher than in year 2 ([600 - 550]/550 = 9.1%).

COMPUTING A PRICE INDEX
.	AMOUNT	PRICE YEAR 1	PRICE YEAR 2	PRICE YEAR 3
Hamburgers	3	.75	.70	.90
Colas	8 cans	.25	.30	.30
Gasoline	1 gallon	.75	1.00	.90
Cost of the Market Basket		5.00	5.50	6.00
Price Index		100.00	110.00	120.00

To compute the price index, the cost of the market basket in any period is divided by the cost of the market basket in the base period, and the result is multiplied by 100. In the table above, year 1 is the base year. The price index for year 3 is:

Price Index = (P₃/P_b) x 100 = (6.00/5.00) x100 = 120.00

The price index tries to give in one number a general picture of what is happening to a great many numbers. As the example shows, some prices may actually be declining while the price index is rising. These prices were not ignored by the price index; rather their contribution was less important to the overall result than the contribution of items whose prices rose.

The construction of a number of other important economic data series uses the method of the price index. The Dow Jones Industrial Average, which many people watch to learn about what the stock market is doing, uses a market basket of 30 stocks. (Notice that the stock market is an aggregated market made up of the markets for hundreds of individual stocks.) We will take a brief look at the Index of Leading Economic Indicators which is now published by the Conference Board. Other widely-reported indexes include the Index of Producer Prices (which used to be called the Wholesale Price Index) published by the Commerce Department and the Index of Industrial Production published by the Federal Reserve System.

Next we see how inflation-adjusted or real measures are computed with a price index.