2.4 — Price Indices and Inflation

Inflation is the rising general level of prices over time, which reduces the purchasing power of money. It is a key economic indicator that affects consumers, businesses, and governments. Inflation has its side effects and consequences, which are further described in 2.5 — Costs of Inflation.

Price Indices

Price indices measure average price changes for a group of goods and services over time. The most commonly used price indices is the Consumer Price Index, which measures the average change in prices of a “market basket” of goods and services consumed by households.

It is calculated by:

$$\text{CPI}=\frac{\text{Cost of Market Basket in Current Year}}{\text{Cost of Market Basket in Base Year}}\times 100$$

For example, a CPI of 120 means prices are 20% higher than the base year.

Inflation Rate

The inflation rate is the percentage change in the price level from one period to the next.

$$\text{Inflation Rate}=\frac{{\text{CPI}}_{\text{new}}-{\text{CPI}}_{\text{old}}}{{\text{CPI}}_{\text{old}}}\times 100$$

Due to inflation, we use both nominal and real values while evaluating the economy and price level:

1. Nominal Values:
   • Measured in current prices.
   • Example: Nominal wages.
2. Real Values:
   • Adjusted for inflation to reflect purchasing power.
   • Formula for real values:$$ \text{Real Value} = \frac{\text{Nominal Value}}{\text{CPI}} \times 100

GDP Deflator

The GDP deflator measures inflation across all goods/services in the economy. Unlike CPI, it includes changes in consumption patterns.

$$\text{GDP Deflator}=\frac{\text{Nominal GDP}}{\text{Real GDP}}\times 100$$