103 Calculating Inflation with Index Numbers
Learning Objectives
- Explain what a price index is and how to compute one
- Calculate inflation rates using price indices
The Price of a Basket of Goods
If inflation is the percentage change of the price level, what is the “price level”? When economists talk about the price level, what they mean is the average level of prices. To calculate the price level, they begin with the concept of a market basket of goods and services. Imagine a weekly trip to the grocery store. Think about the items you place in your shopping cart (or basket) to buy. That is your market basket. More formally, when economists talk about a market basket of goods and services, they are referring to the different items individuals, businesses, or organizations typically buy.
The next step is to identify the prices of those items, and create a weighted average of the prices. Changes in the prices of goods for which people spend a larger share of their incomes will matter more than changes in the prices of goods for which people spend a smaller share of their incomes. For example, an increase of 10% in the rental rate on housing matters more to most people than whether the price of carrots rises by 10%. To construct an overall measure of the price level, economists compute a weighted average of the prices of the items in the basket, where the weights are based on the actual quantities of goods and services people buy.
Index Numbers
The numerical results of a calculation based on a basket of goods can get a little messy. To simplify the task, the price level in each period is typically reported as an index number, rather than as the dollar amount for buying the basket of goods. Index numbers are unit-free measures of economic indicators. Index numbers are based on a value of 100, which makes it easy to measure percent changes. We’ll explain this shortly.
Index numbers for prices are called price indices. A price index is essentially the weighted average of prices of a certain type of good or service. Price indices can measure a narrow range of goods and services or a broader range of goods and services. There are price indices for restaurant meals, for groceries, for consumer goods and services, or for everything included in GDP. Figure 2 shows price indices for U.S. higher education, healthcare and groceries, for the period 1990-2015, which are computed by the Bureau of Economic Analysis in the U.S. Commerce Department. Each price index has a base year of 1990 and increases over time. The price index for groceries increased by 70% over the 25-year period. You can see this since the price index increased from a value of 100 in 1990 to a value of 170 in 2015. The price index for healthcare increased by 213% over the same period, and the price index for higher education, which includes tuition, room, board, textbooks and other fees, increased nearly 450% over the period.
Price indices are created to help calculate the percent change in