MAcro CHAPTER 2.4:

CHAPTER SUMMARY

Prices of goods & services change over time - the rise of market prices over time across the whole economy is called inflation. Disinflation is when prices increase, but at a decreasing rate, and deflation is when prices fall. Of these three, though, inflation is the most common term. This is because, just like GDP, although prices go up and down a lot, we usually see inflation in the long run.

So how can we measure inflation? It's not so easy, because the price of hot dogs might rise a lot, while the price of bread rises a little, while the price of houses falls. To try to measure inflation, the US government uses a measurement called the Consumer Price Index, or CPI. They start by picking out a "basket of goods" - a bunch of different things that consumers might buy. This basket includes things like food, energy, services, clothing, and many other products. The biggest item in the basket of goods is home rental, which makes up about 1/3 of the total CPI because it often makes up about 1/3 of people's total spending.

After we have created our basket of goods, we look at the total cost of the basket of goods in one year, and then the next. The change in percentage between one year and the next is known as the inflation rate.

In the example above, a basket of goods cost $20 in 2022, and $22 in 2023. If this was our representative basket that we use to calculate GDP, the inflation rate from 2022 to 2023 would be 10%. This is because $22 is a 10% increase from $20. In the CPI, we choose a base year, which is the starting year of the calculation. We set the base year CPI at 100, so if CPI 10 years later is 200, this means consumer prices have doubled over 10 years.

Now that we understand inflation, we can also understand the meaning of nominal and real in economics. Real means "adjusted for inflation." Looking at the example above, if your salary went up from $50,000 to $55,000, your nominal income went up by 10%. However, are you able to buy more stuff than before?

When you had $50,000 and the basket of goods cost $20, you could buy 2,500 baskets with your income. Now, with $55,000 and a basket of goods costing $22, you can buy...2,500 baskets. This means that, while your nominal income rose, your real income did not, because even though the number went up, you cannot buy more goods and services than before.

If your nominal income goes up by 3%/year, but the inflation rate is 8%/year, this means your real income is actually going down! Because of this, many contracts include annual cost-of-living adjustments to make sure that the salaries rise with inflation.

In addition to CPI, we can also measure inflation from the perspective of producers (Producer Price Index - PPI) and in the labor market (Employment Cost Index - ECI). Usually, all of these indices (in-dih-seez) move pretty closely together because a change in one causes a change in the others.

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