As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume. While inflation is a regular annual occurrence in modern economic systems, it only becomes a policy concern when reaching unacceptably high levels. As we shall see, many modern economic policymakers have developed a short fuse for reacting to potential increases in inflation. To the majority of us, small doses of annual inflation seem normal and uneventful. Historically, despite bursts of sustained inflation during the Roman Empire, the Middle Ages and the reign in England of Queen Elizabeth I, prices remained broadly stable over long periods, including periods of falling prices. In fact, the average price level in Britain in the early 1930s was no higher than in the 1660s. Measuring Inflation
An inflation rate gives us a consensus or aggregate measure of the price changes occurring for a number of different goods and services. When we look at individual goods, price changes often vary greatly. During the past decades the price of goods such as automobiles, gasoline, movies, health care, and housing have increased significantly. In contrast, the price of calculators and computing power has decreased substantially. There are many different measures of inflation; we will focus on the most common index known as the consumer price index (CPI). There are several steps taken in calculating the current CPI: 1. Measuring the price changes of all goods is complex if not impossible. Instead a market basket of goods is used which represents many of the goods and services that we consume frequently. Items such as housing, food, transportation, communication, etc. are represented by specific goods whose price changes can be accurately recorded over time. 2. The individual items in the market basket are weighted as to their relative importance. The price of gasoline will receive a more significant weighting than that of tomatoes since we spend a greater percentage of our budget on fuel. 3. The prices of individual items and their respective weights are used in calculating the CPI. The inflation rate for 2002 represents the rate of price increases of the weighted basket of goods (the CPI) since 2001. The calculation is: Inflation rate (2002) = | CPI (2002) - CPI (2001)|
| | x 100|
| CPI (2001)| |
Although the consumer price index receives the lion's share of publicity and is the most closely followed price index, astute inflation watchers expand their horizons to include other price indexes. The two most important are the producer price index (PPI) and the wholesale price index. The PPI measures the average price level of goods sold by producers to wholesalers. This is a leading indicator, as higher producer prices are often translated into higher consumer prices. The wholesale price index measures the average price level of goods sold by wholesalers to retailers. The CPI May Overestimate Inflation
The CPI is the most commonly used price index to measure the inflation rate. However, the CPI has several limitations that may cause it to report higher inflation rates than are actually occurring. The main flaws with using the CPI as a measure of consumer prices are:
a. The CPI fails to adjust for improvements in quality.
Over time we often pay more for a good. Compare the price of a Chrysler LeBaron convertible in 1995 to its price in 1985. However, along with the price increase have come substantial improvements in quality. After putting out dismal products in the 1980s, Chrysler made substantial quality improvements in the 1990s. The modern LeBaron buyers enjoy features such as CD stereo players, safety air bags, and a number of other quality improvements that add to the car's value. According to the CPI, we pay more for the...