Using a Price Index to Measure Inflation for a Simple Economy with One Product

Using a Price Index to Measure Inflation for a Simple Economy with One Product

Consider a simple economy that only produces one product, widgets. The following table contains relevant data for this economy.

Year
Price of Widgets (P)
Quantity of Widgets Produced (Q)
Gross Domestic Product
2003
$0.50
10
$5.00
2004
$0.80
20
$16.00
2005
$1.00
50
$50.00
Table 5. Hypothetical data for an economy that only produces one product, widgets.

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.
Let 2003 be the base year. Let the basket of goods be the output produced in the base year. Thus the basket of goods contains 10 widgets. (Note: The basket of goods does not have to be output in the base year.)


Step 2. Find the price of each good in each year.

The prices of the widgets are given in the second column of the table.



Step 3. Compute the cost of the basket of goods in each year.

The basket of goods from 2003 valued at 2003 prices =
(10 widgets) ($.50 per widget) = $5.00

The basket of goods from 2003 valued at 2004 prices =
(10 widgets) ($.80 per widget) = $8.00

The basket of goods from 2003 valued at 2005 prices =
(10 widgets) ($1.00 per widget) = $10.00



Step 4. Compute the price index for each year.


Price index for 2003





Thus, the price index for 2003 is 100. The value of an index in the base year is always 100.


Price index for 2004





Thus, the price index for 2004 is 160.



Price index for 2005





Thus, the price index for 2005 is 200.


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



Calculate the inflation rate between 2003 and 2004

The inflation rate between 2003 and 2004 for this simple economy can be calculated from the price indexes above.


Thus, the rate of inflation between 2003 and 2004 is 60%.


Calculate the inflation rate between 2004 and 2005

The inflation rate between 2004 and 2005 for this simple economy also can be calculated from the price indexes above.



Thus, the rate of inflation between 2004 and 2005 is 25%.

Calculate the inflation rate between 2003 and 2005

The inflation rate between 2003 and 2005 for this simple economy also can be calculated from the price indexes above.



Thus, the rate of inflation between 2003 and 2005 is 100%. Prices in this simple economy doubled between 2003 and 2005.