7.1: Introduction

Prices

What are prices? Some people -- consumers, for example -- would say prices are the cost of goods and services. Others, such as salespeople, would call prices a source of income. And, you know, they are both right. However, if you need a definition that will satisfy everyone, the following should work perfectly:

Prices are a form of communication.

Our complex global market system works as well as it does due, in part, to the fact that all participants (consumers, businesses, and governments) are able to effectively communicate with each other. The price mechanism allows buyers and sellers to state their requirements in the marketplace so that little time and resources are wasted telling each other what they want.

How are messages sent? Good question! Here are two examples of buyer-seller communication.

• A seller who on a daily basis finds herself alone in her store with shelves filled with unsold merchandise is being sent a clear message by her customers: your prices are too high!
• A seller who finds herself cast aside on the sales floor by customers surging past to get to the last unit on the barren and nearly unhinged shelves is being sent a message: your prices are too low.

Prices act as signals to induce producers to produce the things we value most at the lowest cost. The right prices ensure that the economy maximizes the total welfare of its participants.

Inflation

Inflation is simply the persistent rise in the average price level of goods and services. Although that definition may seem clear, many aspects of inflation are cloudy and difficult to define.

Carefully defining and measuring inflation helps us examine economic data more effectively. For example, major economic indicators (such as retail sales or housing starts) report on the past, present, and future health of the economy. Indicators such as housing starts and retail sales report directly on the economy's level of activity. In other words, these indicators examine volumes of output.

When measuring economic output changes, directly counting all individual units is often impractical and confusing. Instead, we calculate the output's value, which incorporates both volume and price. However, when comparing values between periods, we must isolate the volume component by removing price effects to accurately quantify how changes in output alone contribute to economic growth. This principle applies to GDP and other economic metrics where distinguishing between real and nominal changes is essential for meaningful analysis.

real: refers to values that have been adjusted for inflation, reflecting the actual purchasing power or quantity rather than nominal (face-value) amounts.

For example:

• Real GDP measures the total value of goods and services produced in an economy, adjusted for inflation, to compare economic output over time more accurately.
• Real wages indicate income adjusted for changes in price levels, showing the true purchasing power of earnings.

nominal: refers to values that are measured in current prices and have not been adjusted for inflation. Nominal values reflect the face value of money at a given time but do not account for changes in purchasing power over time.

For example:

• Nominal GDP measures the total value of goods and services produced in an economy using current prices, without adjusting for inflation.
• Nominal wages indicate the amount of money earned by workers in current dollars, without considering how inflation affects purchasing power.

Because nominal values can be distorted by inflation, economists often use real values to make more accurate comparisons over time.

If output remains constant and prices increase, then the value of output has been inflated. We say it is inflated because the increase in value was not due to an increase in economic activity (i.e., more output) but merely to a change in the price level. Many analysts are more interested in tracking the changes in output volume than changes in prices. To compensate for the distorting effects inflation has on value calculations, we must deflate our results to arrive at the "real" value.

Figure 1

The real GDP (blue line) in figure 1 does not rise as fast as nominal GDP (green line) because real GDP is adjusted for inflation, while nominal GDP is not. Over time, inflation increases the general price level, causing nominal GDP to grow at a faster rate even if the actual quantity of goods and services produced does not increase as much.

The widening gap between the two lines in the graph suggests that inflation has been persistent over this period, raising nominal GDP more than real GDP. The sharp dip around Q2 2020 represents the COVID-19 economic contraction, where both real and nominal GDP fell, but the divergence afterward highlights the impact of rising prices in the recovery phase.