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Price Indices

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Price Indices

Did you ever wonder why some things were cheaper when older family members were growing up and why those things are so expensive now? It has to do with inflation. But how can you tell if prices are getting higher or lower? And how does the government know when to step in to stop prices from getting out of control? The simple answer is price indices. When governments are aware of the situation via price indices, then they can take the necessary steps to stop the negative effects of price changes. To find out how to calculate price indices, the types, and more, keep reading.

Price Indices definition

Much like economic experts prefer a specific number to describe the main level of output, they prefer a single specific number to indicate the general level of prices, or the aggregate price level.

Aggregate price level is a gauge of the economy's total price level.

Real wages are earnings taking inflation into account, or earnings expressed in terms of the quantity of products or services that may be purchased.

But the economy produces and consumes so many and such a wide range of commodities and services. How can we possibly sum up the pricing of all of these items and services into a single figure? The answer is a pricing index.

A pricing index calculates the cost of buying a specific market basket in a particular year.

Assume a conflict breaks out in a country on which your society relies for crucial food goods. As a result, the price of flour goes up from $8 to $10 per bag, the price of oil goes up from $2 to $5 each bottle, and the price of corn goes up from $3 to $5 every pack. How much has the cost of this imported vital food risen?

One approach to finding out is to mention three numbers: the price changes for flour, oil, and corn. However, this would take a long time to complete. It would be much easier if we had some type of general metric of the average price change rather than worrying about three separate numbers.

Economists monitor differences in the cost of an average customer's consumption bundle—the average basket of products and services purchased before the price fluctuates—to estimate average price changes for products and services. A market basket is a theoretical consumption bundle that is used to track changes in the overall price level.

A consumption bundle is the average basket of products and services purchased before the price fluctuates.

A market basket is a theoretical consumption bundle that is used to track changes in the overall price level.

Real vs nominal values

Labor becomes less expensive when the real salary that corporations pay their employees declines. However, because the quantity of product generated per unit of labor remains constant, corporations opt to recruit additional workers in order to raise profits. When businesses recruit additional workers, output rises. As a result, when the price level increases, output increases.

Essentially, the reality is that even in the case that nominal wages go up during inflation, that doesn't mean that real wages will also go up. There is an approximate formula used for figuring out the real rate:

Nominal rates don't take inflation rates into account, but real rates do.

For this reason, real rates should be used instead of nominal rates to figure out a person's purchasing power.

If the nominal wages rise by 10% but the inflation rate is at 12%, then the rate of change of the real wages is:

Real wages rate = 10% - 12% = -2%

Which means that the real wages, which represent the purchasing power, actually fell!

Price indices calculation and example

Economists all have a similar strategy for tracking changes in the general price level: they examine changes in the cost of purchasing a specific market basket. Using a market basket and a base year, we can calculate a price index (a measure of the total price level). It is always used in conjunction with the year for which the aggregate price level is being assessed along with the base year.

Price Indices Formula

The following formula can be used to construct a price index:

Let's try an example out:

Suppose our basket consists of only three things: flour, oil, and salt. Using the following prices and amounts in 2020 and 2021, calculate the price index for 2021.

ItemQuantity2020 Price2021 Price
Flour10$5$8
Oil10$2$4
Salt10$2$3

Table 1. Sample of Goods, StudySmarter

Step 1:

Calculate the market basket values for both 2020 and 2021. Quantities will be indicated in bold.

2020 market basket value = (10 x 5) + (10 x 2) + (10 x 2)

= (50) + (20) +(20)

= 90

2021 market basket value = (10 x 8) + (10 x 4) + (10 x 3)

= (80) + (40) + (30)

= 150

It's worth noting that the same numbers for quantities were used in both computations. The quantities of goods would certainly fluctuate from year to year, but we want to keep these amounts constant so that we can examine the influence of price fluctuations.

Step 2:

Determine the base year and the year of interest.

The instructions were to find the price index for the year 2021 so that is our year of interest, and 2020 is our base year.

Step 3:

Input the numbers into the price index formula and solve.

The price index for 2021 is 167!

This means that the average price increase was 67% in 2021 compared to the base year - 2020.

Types of Price Indices

Inflation is determined by forming inflation indices and these indices essentially are a reflection of the price level at a certain point in time. The index does not contain all prices, but rather a specific basket of products and services. The specific basket used in the index represents the products that are significant to a sector or group. As a result, multiple price indices exist for the costs encountered by various groups. The main ones are as follows: Consumer Price Index (CPI), Producer Price Index (PPI) and Gross Domestic Product (GDP) Deflator. The percent change in a price index, such as the CPI or the GDP deflator, is used to calculate the inflation rate.

Consumer Price Index (CPI)

The consumer price index (commonly known as the CPI) is the most commonly used indicator of the total price level in the United States, and it is meant to represent how the cost of all transactions made by a typical urban household has altered over a set period of time. It is determined by polling market prices for a specific market basket which is designed to depict the expenditure of an average family of four residing in a standard American city.

The CPI is calculated monthly by the U.S. Bureau of Labor Statistics (BLS) and has been calculated since 1913. It's founded on the index average from 1982 to 1984, which was fixed at 100. Using this as a base, a CPI value of 100 indicates that inflation has returned to the rate it was in 1984, and readings of 175 and 225 imply a 75% and 125% increase in inflation, accordingly.

Consumer Price Index (CPI) is a calculation of the cost of an average American family's market basket.

Price Indices 2021 CPI StudySmarter OriginalsFigure 1. 2021 CPI, StudySmarter Originals. Source: Bureau of Labor Statistics

As shown in Figure 1, this chart depicts the percentage shares of key kinds of spending in the CPI. Vehicles (both used and new) and motor fuel accounted for about half of the CPI market basket on their own. But why is it so important? Simply put, it is a good technique for determining how the economy is doing in terms of inflation and deflation. Individually, it's a great way to get a feel of how costs are evolving. This might help you arrange your budget more effectively. It can also influence how you intend to save your money or start investing.

Unfortunately, the CPI as an inflation metric has some flaws, including substitution bias, which causes it to exaggerate the actual inflation rate.

The substitution bias is a flaw found in the CPI that causes it to exaggerate inflation since it does not factor in when customers opt to substitute one product for another when the price of the product they regularly buy falls.

The consumer price index (CPI) also quantifies the change in salary required by a consumer over time to maintain the same quality of living with a new range of prices as was had under the previous range of prices

Producer Price Index (PPI)

The producer price index (PPI) calculates the cost of a standard basket of goods and services bought by manufacturers. Because product producers are typically quick to increase prices when they detect a shift in public demand for their products, the PPI frequently reacts to rising or falling inflation trends faster than the CPI. As a result, the PPI is frequently seen as a helpful early detection of changes in the rate of inflation.

The PPI differs from the CPI in that it analyzes expenses from the standpoint of the companies that manufacture the items, while the CPI analyzes expenses from the standpoint of consumers.

The producer price index (PPI) evaluates the prices of products and services bought by manufacturers.

Price Indices: Gross Domestic Product (GDP) Deflator

The GDP price deflator, aka the GDP deflator or the implicit price deflator, tracks price changes for all products and services manufactured in a particular economy. Its use allows economists to compare the amounts of actual economic activity from one year to the next. Because it is not dependent on a predefined basket of commodities, the GDP price deflator is a more comprehensive inflation measure than the CPI index.

GDP deflator is a way to track price changes for all products and services manufactured in a particular economy.

It's 100 times the nominal GDP vs real GDP ratio in that year.

I's not technically a price index, but it has the same purpose. It's important to remember the difference between nominal GDP (GDP in today's costs) and real GDP (GDP analyzed using the prices of some base year). The GDP deflator for a particular year is equal to 100 times the nominal GDP to real GDP ratio for that year. Because the Bureau of Economic Analysis—the source of the GDP deflator—analyzes the real GDP using 2005 as the base year, both GDPs for 2005 are identical. As a result, the GDP deflator for 2005 is 100.

Nominal GDP is the total worth of all final products and services generated in an economy throughout a particular year, measured using current prices in the year the output is created.

Real GDP is the total worth of all final products and services produced in an economy throughout a given year, computed using prices from a chosen base year to exclude the impact of price fluctuations.

Importance of Price Indices

Indices aren't just calculated for no reason. They have a significant influence on policymakers' choices and the economy's functioning. For example, they have a direct impact on the earnings of union employees who get cost-of-living modifications based on the consumer price index (CPI).

These indices are also frequently used by employers and employees to assess "fair" compensation raises. Some federal programs, such as social security, determine monthly check modifications based on a form of one of these indices.

The cost of living index data can also be used to assess the working class's living conditions. Salaries in certain regions are modified according to changes in the cost of living price index, so that employees are not strained when prices go up.

Price Indices - Key takeaways

  • To know the aggregate price level, economists figure out the cost of buying a market basket.

  • A price index calculates the cost of buying a specific market basket in a particular year.

  • The yearly percentage change in a price index, commonly the CPI, is used to compute the inflation rate.

  • The three main types of price indices are the CPI, PPI, and GDP deflator.

  • To calculate the price index, use the following formula:


Sources:

Bureau of Labor Statistics, Consumer Price Index: 2021, 2022

Frequently Asked Questions about Price Indices

A pricing index is a calculation of the cost of buying a specific market basket in a particular year.

The three main types of price indices are the CPI, PPI, and GDP deflator.

They sum up the pricing of all items and services into a single figure.

(Cost of market basket in a chosen year) / (Cost of market basket in base year). Multiply the answer by 100. 

CPI is an example of a price index. It is the most commonly used indicator of the total price level in the United States.

Final Price Indices Quiz

Question

What is a price index?

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Answer

A pricing index calculates the cost of buying a specific market basket in a particular year.

Show question

Question

What's an aggregate price level?

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Answer

Aggregate price level is an estimate of the economy's total price level.

Show question

Question

What's a market basket?

Show answer

Answer

A market basket is a theoretical consumption bundle that is used to track changes in the overall price level.

Show question

Question

What are the different price indices?


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Answer

The three main types of price indices are the CPI, PPI, and GDP deflator.

Show question

Question

How do price indices work?

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Answer

They sum up the pricing of all items and services into a single figure.

Show question

Question

What's a consumption bundle?

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Answer

A consumption bundle is the average basket of products and services purchased before the price fluctuates.

Show question

Question

What's the most commonly used price index in the US?

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Answer

The CPI (Consumer Price Index)

Show question

Question

What's the CPI?

Show answer

Answer

Consumer Price Index (CPI) is a calculation of the cost of an average American family's market basket.

Show question

Question

Why is knowing the CPI helpful?

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Answer

It's a great way to get a feel of how costs are evolving, which could help you arrange your budget more effectively. It can also influence how you intend to save your money or start investing.

Show question

Question

What's the GDP deflator?

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Answer

GDP deflator is a way to track price changes for all products and services manufactured/produced in a particular economy. It's 100 times the nominal GDP vs real GDP ratio in that year.

Show question

Question

Define nominal GDP

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Answer

Nominal GDP is the total worth of all final products and services generated in an economy throughout a particular year, measured using current prices in the year the output is created.

Show question

Question

Define real GDP

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Answer

Real GDP is the total worth of all final products and services generated in an economy throughout a given year, computed using prices from a chosen base year to exclude the impact of price fluctuations.

Show question

Question

When calculating the market basket value, why do you keep the quantity numbers the same for both the given and base year?

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Answer

The quantities of goods would certainly fluctuate from year to year, but we want to keep these amounts constant so that we can examine the influence of price fluctuations.

Show question

Question

Does an index contain all prices?

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Answer

An index does not contain all prices, but rather a specific basket of products and services

Show question

Question

The ______ ______ is a group, or bundle of goods and services commonly purchased by a segment of the population that is used to track and measure changes in an economy's price levels, and the cost of living facing those segments. 

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Answer

market basket

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Question

The Consumer Price Index is calculated by dividing the cost of the market basket in the _______ year by the cost of the market basket in the ____ year.

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Answer

current, base

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Question

The ____________ is a measure of the relative change over time of prices experienced by urban households in an economy using a representative basket of goods and services. 


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Answer

consumer price index, CPI

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Question

The _________ ____ is the speed, or percentage rate, at which the prices of the goods and services bought by households rise over time.


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Answer

inflation rate

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Question

The inflation rate is calculated by dividing the ________ by the ________ multiplied by 100.

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Answer

CPI current period, CPI base period

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Question

_________ is the speed, or percentage rate, at which the prices of the goods and services bought by households fall over time. 

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Answer

Deflation

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___________ occurs when the speed of price increases is slowing down. 


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Answer

disinflation

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Question

Inflation, deflation, and disinflation can be triggered, or accelerated through ______ ______ or ________ ______


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Answer

monetary policy, fiscal policy

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Question

The ____ __ ______ is the amount of money a household needs in order to buy basic expenses such as housing, food, clothing, and transportation. 


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Answer

cost of living

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Question

In economics, _______ values are the absolute, or actual numerical values of a variable in different periods. 


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Answer

nominal

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Question

____ values reflect nominal values that have been adjusted for inflation.  


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Answer

real

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In order to convert a nominal value into its real value, you would need to divide the nominal value by the ___ of that period and multiply by 100. 


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Answer

CPI, consumer price index

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Question

Money gives individuals and households _________ _____ , which is the ability to acquire goods and services. 

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Answer

purchasing power

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Question

Which of the following is NOT a reason why the CPI might overstate inflation?

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Answer

Foreign investment

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If the CPI in a country was 128.3 in 1990 and 125.6 in 1991, what is the inflation rate in 1991?

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Answer

-2.1%

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Question

What does aggregate price level do?

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Answer

gauges the economy's total price level.

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Question

Wages that take into account inflation and are an indicator of what you can purchase is...

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Answer

Real wages

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What does a pricing index do?

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Answer

Allow us to see the cost of a market basket

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If the nominal wage goes up 13% and inflation goes up 16%, what is the real wage?

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Answer

-3%

Show question

Question

Calculate the price index for 2021. Suppose our basket consists of only three things: flour, oil, and salt. The quantity bought for each item was 15 in both years. In 2020, the prices were:

Flour: $5

Oil: $2

Salt: $1

In 2021:

Flour: $9

Oil: $6

Salt: $5



Show answer

Answer

286

Show question

Question

Calculate the price index for 2021. Suppose our basket consists of only three things: flour, oil, and salt. The quantity bought for each item was 13 in both years. In 2020, the prices were:

Flour: $3

Oil: $3

Salt: $1

In 2021:

Flour: $5

Oil: $6

Salt: $4

Show answer

Answer

214

Show question

Question

What is the most commonly used price indicator in the U.S.?

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Answer

Consumer Price Index

Show question

Question

Substitution bias is a flaw of which price index?

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Answer

CPI

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Question

Which price index tracks the cost of a standard basket bought by manufacturers?

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Answer

PPI

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Question

Which price index tracks the price changes for products produced in a particular economy?

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Answer

GDP Deflator

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Question

True or False: PPI is subject to fast price changes from manufacturers.

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Answer

True

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True or False: The GDP price deflator is a more comprehensive inflation measure than the CPI index.

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Answer

True

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True or False: The CPI is calculated monthly by the Fed.


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Answer

False

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What base year is used for GDP Deflator?

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Answer

2005

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True or False: Real GDP is the total worth of all final products and services generated in an economy throughout a particular year, measured using current prices in the year the output is created.

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Answer

False

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True or False: A consumption bundle is the average basket of products and services purchased before the price fluctuates.

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Answer

True

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Question

Nominal wages went up 15%, inflation went up 13 %. What happened to real wages?

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Answer

Went up 2%

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Nominal wages went up 12%, inflation went up 13%. What happened to real wages?

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Answer

Went down 1%

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True or False: The percent change in a price index, such as the CPI or the GDP deflator, is used to calculate the interest rate.

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Answer

False

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Question

True or False: GDP deflator is a way to track price changes for all products and services manufactured in a particular economy. 

It's 120 times the nominal GDP vs real GDP ratio in that year.

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Answer

False

Show question

Question

Which of the following is the correct way to calculate CPI?

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Answer

Total cost of this period / Total cost of base period X 100

Show question

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