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About this Lesson
 Type: Video Tutorial
 Length: 11:19
 Media: Video/mp4
 Use: Watch Online & Download
 Access Period: Unrestricted
 Download: MP4 (iPod compatible)
 Size: 121 MB
 Posted: 03/29/2010
This lesson is part of the following series:
Economics: Full Course (269 lessons, $198.00)
Economics: Macroeconomic Measurements (16 lessons, $25.74)
Economics: Cost of Living (5 lessons, $8.91)
In this video lesson, you'll learn to calculate the Rate of Inflation. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.
Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.
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 Thinkwell
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Now here's a mystery: On the front page of the paper, it says that the inflation rate last year was about 3%. And yet, on page 14, there's a story that says the inflation rate was practically zero last year. How can that be true? Well, if you look closer, you'll see that on the front page, the inflation rate is being measured using the GDP Deflator. Whereas, inside, the inflation rate is being measured using the Consumer Price Index (CPI). Still, what accounts for the difference? Well, we know that the Consumer Price Index is measured using a narrower basket of goods and services, whereas the GDP Deflator is based on all prices in the economy. Perhaps that accounts for the difference. We're going to look closer now at a simple example to show how the GDP Deflator and the Consumer Price Index can lead to different calculations of the rate of inflation.
Let's go back to our simple economy with just apples and bananas and look at the difference between the method of calculating the rate of inflation using the GDP Deflator and the method for calculating inflation using the Consumer Price Index. Remember, with the GDP Deflator, we're taking a ration between the nominal GDP in a given year and the real GDP in that same year. And what we're doing to calculate the real GDP is we're using the current year's quantities, but the prices from some base year. In our simple example, we were using the Year 1 prices, multiplying the quantity of apples in Year 2 by the price of apples in Year 1, and the quantity of bananas in Year 2 by the prices of bananas in Year 1. And the ratio between $16 and $12 gave us the rate of inflation using the GDP Deflator method. The simple statement here is we are using current year quantities to weight the change in prices.
So, we calculate the GDP Deflator using the actual quantities of goods and services produced in the economy in the current year. We calculate the Consumer Price Index, on the other hand, using a predetermined basket of goods and services. That basket of goods and services stays the same from one year to the next as we calculate the inflation rate, and that's what makes all the difference. Let's look at how that works in the example of our simple economy with apples and bananas.
The Consumer Price Index requires that we find the market bundle of goods and services that we're going to use as our base case. Let's choose the Year 1 quantities for that market basket. That is, we're going to say that the typical household consumes 2 apples and 3 bananas. And we're going to look at how the price of that market basket changes from one year to the next. Let's start then by calculating the cost of that market basket in Year 1. Using the prices from Year 1: $1 times 2 apples is $2 for apples, and $2 per banana times 3 bananas is $6 for bananas, for a total price of that market basket of $8. Now, what happens as we move from Year 1 to Year 2? Again, ignore the Year 2 quantities. They are not relevant for the Consumer Price Index. We're focused on what happens to the price of that market basket that we've defined as 2 apples and 3 bananas. Let's use now the prices from Year 2. Year 2 price times Year 1 quantities gives us $1.50 per apple times 2 apples, or $3 for apples, and $2.50 per banana times 3 bananas, or a total of $7.50 for bananas. That adds up to a grand total of $10.50 to purchase that market basket after prices have risen. The whole idea then with the Consumer Price Index is a fixed basket of goods and services and how the cost of that basket changes as prices change from one year to the next.
Now we're ready to calculate the Consumer Price Index. It's simply the cost of that market basket of goods in the current year divided by the cost of the same market basket in the base year, multiplied by 100. Now that we've calculated the cost of the market basket in two years, we're ready to calculate the CPI. Let's start with the base year, which is kind of a trivial case. The cost of the market basket in the base year divided by the cost of the market basket in the base year will always be 1. And when you multiply that by 100, you will get 100. The consumer price index is always 100 for the base year. Now, let's take a more interesting case: Year 2. In Year 2, the cost of the market basket is equal to $10.50. Divide that by $8, the cost of the market basket in the base year. Multiply by 100 and you get that the CPI in Year 2 is equal to 131.25. Once you've got the Consumer Price Index in two years, you can calculate the rate of inflation between those yearsthat is, what happened to prices between Year 1 and Year 2 according to the CPI. Well, let's calculate the rate of inflation between those two years using the CPI. And we'll get 131.25the CPI in Year 2minus 100the CPI in year 1, our base yeardivided by 100, the CPI in our base year. Well, when you do that math, you find that the percentage change is 31.25%. That is, the rate of inflation measured according to the Consumer Price Index is 31.25%. Now, hold on. It wasn't that long ago that we calculated the rate of inflation according to the GDP Deflator and we got a different number all together. In fact, you'll recall we got 33.33%.
What gives here? Why are we getting different numbers for calculating the rate of inflation? It's because the method of accounting for price changes is different in the two cases. First of all, the GDP Deflator looks at all of the goods produced in the economy, while the Consumer Price Index looks at only a specific market basket of goods. Moreover, the Consumer Price Index might include imports, whereas the GDP Deflator is based on domestic production. Finally, the Consumer Price Index uses a base year, and it sets quantities with respect to a base year, while the GDP Deflator looks at quantities in the current year to weight changes in prices.
These three changes, specific market basket versus the whole economy, imports versus no imports, and finally, base year quantities versus current year quantities will give us the differences that we measure in the inflation rates depending on which of the two methods we're focused on. So, Consumer Price Index and GDP Deflator are two paths to figure out what's happening to prices in the economy. But the paths wind in different ways, and it's important to understand the differences when you see two different reports of the inflation rate. Next time you see that, you'll know what's going on.
Macroeconomic Measurements
Cost of Living
Calculating the Rate of Inflation Page [1 of 2]
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