2.4: Price Indices and Inflation Flashcards
What is inflation?
rising general prices & it reduces the “purchasing power” of money
ex. It takes $2 to buy what $1 bought in 1990
When inflation occurs, each dollar buys fewer goods and services than before
Is inflation good or bad?
In general, high inflation is bad b/c banks don’t lend money and people don’t save.
Decrease in Investment & GDP
What is deflation?
decrease in general prices or a negative inflation rate
Is deflation good or bad?
Bad b/c people will hoard money and assets
decrease in consumer spending & GDP
Disinflation
Prices increasing at a slower rates
How is inflation measured?
The gov. tracks the prices of specific “market baskets” that include the same goods and services.
There are two ways to look at inflation over time.
The Inflation Rate
The % change in prices from year to year
Ex. The U.S. inflation rate in 2014 was .8%
Price Indices
Index numbers assigned to each year that show how prices have changed relative to a specific base year
Ex: The Consumer Price Index for 2014 was 235 ( base year 1982) This means that prices have increased 135% since 1982
What is in the Market Basket?
Food & Beverages, Housing, Apparel, Transportation, Medical Care, Recreation, Education & Communication, Other Goods & Services
What is the most commonly used measurement of inflation for consumers?
Consumer Price Index (CPI)
How does CPI works?
The base year is given an index of 100.
To compare, each year is given an index # as well
CPI = Price of market basket/ price of market basket in base year multiply by 100.
Ex: 1997: Market Basket: Movie is $6 & Pizza is $14 Total= $20 (CPI of Base Tear is 100)
2009 Market Basket: Movie is $8 & Pizza is $17 Total= 25 ( CPI of 2009 is 125)
Meaning inflation increased 25% b/tw 1997 & 2009. Items that cost $100 in 1997 cost $125 in 2009.
Substitution Bias
As prices increase for the fixed market basket, consumers buy less of these products & more substitutes that may not be part of the market basket. ( Result: CPI may be higher than what consumers are really paying)
Problem w/ CPI
New Products
The CPI market basket may not include the newest consumer products. (Result: CPI measures prices but not the increase in choices.)
Problem w/ CPI
Product Quality
The CPI ignores both improvements & decline in product quality
(Result: CPI May suggest that prices stay the same though the economic well being has improved significantly)
