- Define inflation and deflation, explain how their rates are determined, and articulate why price-level changes matter.
- Explain what a price index is and outline the general steps in computing a price index.
- Describe and compare different price indexes.
- Explain how to convert nominal values to real values and explain why it is useful to make this calculation.
- Discuss the biases that may arise from price indexes that employ fixed market baskets of goods and services.
Concern about changes in the price level has always dominated economic discussion. With inflation in the United States generally averaging only between 2% and 3% each year since 1990, it may seem surprising how much attention the behavior of the price level still commands. Yet inflation was a concern in 2004 when there was fear that the rising price of oil could trigger higher prices in other areas. Just the year before, when inflation fell below 2%, there was talk about the risk of deflation. That did not happen; prices continued rising. Inflation rose substantially in the first half of 2008, renewing fears about subsequent further increases. And 2010 brought renewed concern of possible deflation. Just what are inflation and deflation? How are they measured? And most important, why do we care? These are some of the questions we will explore in this section.
Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling.
There are two key points in these definitions:
- Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling.
- Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. "High" prices do not imply the presence of inflation, nor do "low" prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices.
This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.