Sunday, October 12, 2008

Measurement of Inflation

Measurement of Inflation

Inflation is measured using a basket of goods. A basket of goods is a collection of products used to calculate a price index.

The table below lists the three most commonly used price indexes for measuring inflation in the United States. Each index uses a different basket of goods.

Price Index
Basket of Goods
Consumer Price Index (CPI)
Products purchased by a typical urban household.
Producer Price Index (PPI)
Products produced and sold by U.S. businesses, including goods and services that are used as inputs in the production of other products.



Everything in Gross Domestic Product. Unlike the CPI and PPI, the GDP deflator is not based on a fixed basket of goods.
Table 4. The baskets of goods associated with three price indices used to measure U.S. inflation.

Could you measure price changes by examining the amount of money spent on weekly trips to the grocery store? Probably not, because most people buy at least a few different items each trip to the store. If you bought the same items each time, however, then you would have some indication of what is happening to prices. The CPI and PPI use fixed baskets of goods. They calculate price changes over time to the same collection of items.

The base year is the year that is used as the comparison year when calculating an index. In the following examples, output in the base year is the basket of goods used to calculate the price indexes.

There are five steps to follow when using a price index to measure inflation.
Step 1. Choose the base year and determine the basket of goods.
Step 2. Find the price of each good in each year.
Step 3. Compute the cost of the basket of goods in each year.
Step 4. Compute the price index for each year.


Step 5. Use the price index to calculate the inflation rate.


Table 5. The five steps to follow when using a price index to measure inflation.

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