and the Price Level Chapter Outcomes Calculate the Consumer Price Index Compare and contrast how aggregate demand and aggregate supply affect recessionary and inflationary gaps Differentiate between demand pull and cost push inflation their causes and their impact on price levels Calculate the rate of inflation Discuss the harmful consequences of inflation Real GDP and the Price Level Calculating the Price Level The average level of prices is called the price level The Money Market The Price Level The quantity of money that households and businesses plan to hold is proportional to the price level other things remaining the same If the price level rises by 10 percent people will plan to hold 10 percent more money the quantity of money demanded increases by 10 percent Price Level An indicator of how high or low prices are in a certain year compared to average prices in a certain base period Price Index An index number which shows how weighted average price of a market basket of goods changes through time Ratio that shows percentage change over time Comparison from fixed point of reference Used to measure price level Consumer Price Index The price level is the average level of prices and is measured by using a price index The Consumer Price Index or CPI measures the average level of the prices of goods and services consumed by an urban family The Price Level Consumer Price Index CPI Measures the average level of prices of the goods and services that a typical urban family buys Published monthly by the Bureau of Labor Statistics Must use a base period e g 1982 1984 Market basket Price Level and Inflation The C P I Basket The C P I basket is based on a Consumer Expenditure Survey which is undertaken infrequently The C P I basket today is based on data collected in the Consumer Expenditure Survey of 2019 Price Level and Inflation The Monthly Price Survey Every month B L S employees check the prices of the 80 000 goods in the C P I basket in 30 metropolitan areas Calculating the C P I 1 Find the cost of the C P I basket at base period prices 2 Find the cost of the C P I basket at current period prices 3 Calculate the C P I for the current period CPI Weighted average Indicates relative importance of items in consumer spending Price Level and Inflation Reading the C P I Numbers The C P I is defined to equal 100 for the reference base period Currently the reference base period is 1982 1984 That is for the average of the 36 months from January 1982 through December 1984 the C P I equals 100 In May 2021 the C P I was 269 2 This number tells us that the average of the prices paid by urban consumers for a fixed basket of goods was 169 2 percent higher in May 2021 than it was during 1982 1984 Price Level and Inflation Let s work an example of the CPI calculation In a simple economy people consume only oranges and haircuts The CPI basket is 10 oranges and 5 haircuts The table also shows the prices in the base period The cost of the CPI basket in the base period was 50 Price Level and Inflation Table b shows the fixed CPI basket of goods It also shows the prices in the current period The cost of the CPI basket at current period prices is 70 Price index Cost of a market basket of products in current year Cost of the same market basket of products at prices prevailing in the base period x 100 Price Level and Inflation Using the numbers for the simple example CPI 70 50 100 140 The CPI is 40 percent higher in the current period than it was in the base period The CPI A Simplified Calculation Base Period Price Current period Expenditure Price Expenditure Base period basket 5 pounds of oranges 0 80 pound 4 1 20 pound 6 haircuts 11 00 each 66 12 50 each 100 bus rides 1 40 each 140 1 50 each 150 Total expenditure 6 75 210 231 CPI 210 00 210 00 100 100 231 00 210 00 100 110 Price Level and Inflation Measuring the Inflation Rate The major purpose of the CPI is to measure inflation The inflation rate is the percentage change in the price level from one year to the next Price Level Inflation and Deflation Figure shows the relationship between the price level and the inflation rate The inflation rate is High when the price level is rising rapidly Low when the price level is rising slowly Negative when the price level is falling The Consumer Price Index Constructing the CPI Constructing the CPI involves three stages Selecting the CPI basket Conducting a monthly price survey Using the prices and the basket to calculate the CPI The Consumer Price Index Figure illustrates the CPI basket Housing is the largest component Transportation and food and beverages are the next largest components The remaining components account for only 26 percent of the basket Consumer Price Index Biased CPI CPI may overstate the true inflation for 4 reasons New goods bias Quality change bias Commodity substitution bias Outlet substitution bias Biased CPI New goods bias new goods that were not available in the base year appear and if they are more expensive than the goods they replace the price level may be biased higher Similarly if they are cheaper than the goods they replace but not yet in the CPI basket they bias the CPI upward Quality change bias quality improvements generally are neglected so quality improvements that lead to price hikes are considered purely inflationary Consumer Price Index Commodity substitution bias the market basket of goods used in calculating the CPI is fixed and does not take into account consumers substitutions away from goods whose relative prices increase Outlet substitution bias as the structure of retailing changes people switch to buying from cheaper sources but the CPI as measured does not take account of this outlet substitution Price Level and Inflation The Magnitude of the Bias An estimate made in 1996 says that the C P I overstates inflation by 1 1 percentage points a year Some Consequences of the Bias Distorts private contracts Increases government outlays close to a third of federal government outlays are linked to the C P I The B L S has now corrected much of the bias but some still remains Inflation and the Price Level Inflation is a process in which the price level is rising and money is losing value Inflation is not the increase in the price of one item Inflation is the increase in the price of most items by similar percentages Money Illusion using nominal dollars rather than real dollars to gauge income or wealth Inflation and the Price Level A one time jump in the price level is not