Unit 4 Inflation and unemployment

4.2 Measuring the economy: Inflation

Inflation is a general increase in prices across the economy. The commonly used ‘consumer price inflation’ is measured by the percentage increase in the cost of a representative basket of household goods and services, usually over a year.

To understand what this means, take your favourite chocolate bar. If its price goes up during the year from 50p to 55p, how do you know that is a symptom of inflation in the economy? It could just be that the chocolate bar has become more expensive relative to everything else. Some companies may have left the chocolate bar market, reducing competition, which would allow those remaining to increase their prices. Alternatively, customers may have changed their preference for chocolate relative to other sweet treats, increasing the demand which would increase price, or there may have been a crop failure in an important cocoa-growing region leading to higher-priced cocoa beans. None of these reasons—specific to chocolate bars alone—represent inflation. It would be a symptom of inflation if it was not only the price of chocolate that was increasing, but the prices of a wide basket of goods and services.

To investigate what has happened to the prices across the economy that are relevant to you, you could take a giant shopping basket and fill it with every product and service that you buy in January. Has the price of this same giant basket increased when you check the prices in the following month or year? And what about the baskets of other people? You can explore this later in Exercise 4.1.

consumer price index (CPI)

A measure of the general level of prices that consumers have to pay for goods and services, including consumption taxes.

The consumer price index (CPI) measures the general level of prices that consumers have to pay for goods and services, including consumption taxes. The basket of goods and services is chosen to reflect the spending of a typical household in the economy. For this reason, the change in the CPI, or CPI inflation, is often considered to measure changes in the ‘cost of living’.

The CPI is based on what consumers actually buy. It includes the prices of food and drink, housing, clothing, transportation, recreation, education, communications, medical care, insurance, and other goods and services. The goods and services in the basket are weighted according to the fraction of household spending they account for. The CPI excludes exports, which are consumed by foreign residents, but includes imports, which are consumed by households in the home economy.

To calculate the rate of inflation, there are three steps:

1. find the cost of the basket of goods
2. compute a price index such as the CPI
3. use the CPI to calculate the inflation rate.

Let’s use a basket with three goods as a simple example. Our simple basket will contain rice, chicken, and carrots, in the quantities given in Figure 4.4a.

Let’s set 2020 as our base year. Note that the quantity is held fixed while the prices of the goods vary year by year. The cost of the basket is displayed in the table. The next step is to calculate the CPI (see Figure 4.4b). To do this, we use the following formula:

\[\text{price index (e.g. the CPI)} = \frac{\text{basket price}}{\text{basket price in base year}} \times 100\]

Finally, since inflation is defined as the change in the general level of prices over time, we use the following formula to calculate the rate of inflation:

\[\text{inflation} = \frac{\text{CPI}_\text{this year}-\text{CPI}_\text{last year}}{\text{CPI}_\text{last year}} \times 100\]

For 2021, the inflation rate is equal to \((142.22 − 100)/100 \times 100 = 42.2%\).

For 2022, the inflation rate is equal to \((191.11 − 142.22)/142.22 \times 100 = 34.4%\).

GDP deflator

A measure of the change in the level of prices for domestically produced output, based on price changes of consumption, investment, government expenditure, and exports.

The GDP deflator is a price index like the CPI, but it tracks the change in prices of all domestically produced final goods and services. Instead of a basket of goods and services that a consumer buys, the GDP deflator tracks the price changes of the components of domestic GDP, that is, of \(C + I + G + X − M\). It includes exports, which are produced by the home economy, but excludes imports, which are produced abroad.

The GDP deflator can also be expressed as the ratio of nominal (or current price) GDP to real (or constant price) GDP. The GDP deflator series is most commonly used to transform a nominal GDP series into a real GDP series. The real GDP series shows how the size of the home economy changes over time, taking into account changes in the price of domestically produced goods and services.

In Section 3.4, when discussing the challenges of measuring GDP in real terms, we raised the problem of interpreting changes in prices that may reflect changes in quality. The same issues arise when using a price index to calculate changes in the standard of living, where changes in the price of a good may reflect genuine quality improvements such as new features, rather than economy-wide inflation. Take smartphones: compared to when they were first released, they have bigger screens, better cameras, and faster processors—and unlike earlier mobile phones they are able to act as a GPS, access the internet, and more. Smartphones may have become more expensive over time, but economists calculating CPI want to disentangle the effect of quality improvements on prices from that of inflation.

Describing a change in price level

We used three terms to describe what was happening to the UK price level in Figure 4.1.

The change in the general price level can be positive (inflation) or negative (deflation), and even where there is a positive change it can be smaller than in the previous period (disinflation).