Inflation is defined as an increase in the overall price level. Please note that inflation does not apply to the price level of just one good, but rather to how prices are doing overall. A consumer facing inflation that occurs at the rate of 10% per year will able to buy 10% less goods at the end of the year if his or her income stays the same. Inflation can also be defined as a decline in the real purchasing power of the applicable currency.
Consumer Price Index (CPI)
The CPI represents prices paid by consumers (or households). Prices for a basket of goods are compiled for a certain base period. Price data for the same basket of goods is then collected on a monthly basis. This data is used to compare the prices for a particular month with the prices from a different time period.
The inflation rate is computed by subtracting the CPI of last year's prices from the CPI value for this year, dividing that difference by last year's CPI value and then multiplying by 100.
So if the value of the price index for the current year is equal to 165, and last year's value was 150, the rate would be calculated as:
Inflation rate = (165 - 150) X100= 10
CPI Sources of Bias
The CPI is not a perfect measure of inflation. Sources of bias include:
·Quality adjustments - quality of many goods (e.g., cars, computers, and televisions) goes up every year. Although the Bureau of Labor Statistics is now making adjustments for quality improvements, some price increases may reflect quality adjustments that are still counted entirely as inflation.
·New goods - new goods may be introduced that will be hard to compare to older substitutes.
·Substitution - if the price goes up for one good, consumers may substitute another good that provides similar utility. A common example is beef vs. pork. If the price goes up, and the price of pork stays the same, consumers might easily switch to pork. Although the CPI will go higher due to the price increase in beef, many consumers may not be worse off. Also, when prices go up, consumers may effectively not pay the higher prices by switching to discount stores. The CPI surveys do not check to see if consumers are substituting discount or outlet stores.
Aggregate Supply & Aggregate Demand
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