7.2: Understanding Inflation

When evaluating changes in your economic well-being, price effects are crucial to consider. A 50% income increase sounds substantial, but if prices also rise by 50%, your purchasing power remains unchanged. Despite having more dollars, you can't buy more goods or services - your "real" income stays constant even as your "nominal" income grows.

The essential question is how your purchasing power has changed. Real income growth occurs when your earnings outpace inflation, expanding your ability to acquire goods and services. This distinction between nominal and real changes reveals whether your economic situation has genuinely improved or merely kept pace with rising prices.

Economists use indexes to filter out price effects and determine real values. Earlier in this chapter we discussed that by holding the price level constant (i.e., using constant prices) while allowing certain data, such as income, to fluctuate, you can filter out the effects of changing prices to a certain degree. When economic indicators are published without any adjustment for prices, they are said to be in nominal terms (i.e., current prices). So, when it comes to your paycheck, real income would refer to nominal income adjusted for inflation (i.e., income in constant dollars).

Constructing an Index

Economists construct a price index to measure changes in the overall price level of goods and services over time. The process involves:

1. Selecting a Market Basket – Identifying a representative set of goods and services commonly purchased by households.
2. Collecting Price Data – Tracking the prices of these items over time.
3. Calculating the Cost of the Basket – Determining the total cost of the market basket in a base year and in subsequent years.
4. Computing the Index – Using the formula: \[\text { Price Index }=\left(\frac{\text { Cost of Basket in Current Year }}{\text { Cost of Basket in Base Year }}\right) \times 100 \nonumber \]
5. Adjusting for Inflation – Changes in the index reflect inflation or deflation, helping economists compare purchasing power across time.

Below is a table with annual prices.

Table 1

Year	Prices
1980	6804
1981	6814
1982	6900
1983	7029

If we select 1980 as the base period, we can then create a price index by dividing all prices by the base period price and multiplying that number by 100.

For example, for the year 1981:

\[(6814\div 6804) \times 100 = 100.15 \nonumber \]

Table 2

Year	Prices	Index
1980	6804	100
1981	6814	100.15
1982	6900	101.41
1983	7029	103.31

In this case, the inflation rate is the percentage change in the index values. \[((\text { Index } 1981 \text { / Index 1980) - 1) x } 100 \nonumber \]

For example, for the year 1981:

\[((100.15 / 100)-1) \times 100 = 0.15\%\nonumber \]

Table 3

Year	Prices	Index	Annual Inflation Rate
1980	6804	100	-
1981	6814	100.15	0.15%
1982	6900	101.41	1.26%
1983	7029	103.31	1.87%

The concept of rising and falling prices is not a complicated one. However, you would be surprised how often inflation indicators are misinterpreted by the public and badly reported by the media.

One common mistake is the failure to distinguish between deflation and disinflation. Deflation is simply an outright decline in the average price level. Disinflation, a term not in common use, is the slowing of the inflation rate. For example, read this mock news headline and consider what it means.

Question: Did the economy experience inflation, deflation, or disinflation during April?

Answer: The economy experienced disinflation. From March to April, the economy saw the average price level increase, but at a slower rate.