32 Consumer Price Index
Introduction
This module begins by demonstrating how to combine prices of individual goods and services to create an index of prices, called the Consumer Price Index (CPI), which we then will use to calculate the rate of inflation. Inflation has costs and consequences for people and firms throughout the economy through their roles as lenders and borrowers, wage-earners, taxpayers, and consumers. The module discusses some imperfections and biases regarding CPI and inflation statistics, how to convert dollar values across time so as to make comparisons possible, and historical inflation around the world.
Next, we focus on money, its functions, the Banking System, the Federal Reserve System (Fed) and the Fed’s main policy tools. Last, we explain the relationship between money growth, inflation, and real GDP growth in the long-run via the Quantity Theory of Money. (1)
Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices.
A price index can be used to compare the real value of money between time periods. Have you heard the reminiscing of your elderly relatives about how things were so much better when they were kids? Maybe some of your elders brag about the $.05 Coca-Cola they enjoyed or the $.50 movies they went to when they were younger. When people often complain about the rising price of something, they are nearly always speaking of nominal prices, not real prices. So, in today’s dollars, how much was that famous $.05 Coca-Cola we’ve heard so much about?
If we use 1939 as the starting year, a $.05 Coca-Cola would be the equivalent of paying $.84 in 2013 — which for a 12oz can purchased from a grocery store, would be a bit on the high side (especially if considering the per unit price of purchasing in bulk). What about a $.50 movie? A $.50 movie in 1939 (the year Gone with the Wind was first released), would be $8.40 in 2013 — which is about the same as the 2013 average ticket price. Recall the concept of opportunity cost. If the price of a particular good is rising at a slower rate than other prices of other goods, then the opportunity cost of acquiring that item has actually fallen. (15)
Consumer Price Index
The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. CPI is the most commonly cited measure of inflation in the United States. The CPI is calculated by government statisticians at the U.S. Bureau of Labor Statistics based o