Price-Level Changes

Review section 2 of the Macroeconomics chapter assigned in Unit 2.1, which defines and discusses the concept of Inflation. Learn what hyperinflation and deflation are and identify the method of calculating inflation. Pay attention to the meaning and calculation of the term "Price Index" and the way it is used to calculate inflation.

Price Indexes

Computing Real Values Using Price Indexes

Suppose your uncle started college in 2001 and had a job busing dishes that paid $5 per hour. In 2011 you had the same job; it paid $6 per hour. Which job paid more?

At first glance, the answer is straightforward: $6 is a higher wage than $5. But $1 had greater purchasing power in 2001 than in 2011 because prices were lower in 2001 than in 2011. To obtain a valid comparison of the two wages, we must use dollars of equivalent purchasing power. A value expressed in units of constant purchasing power is a real value. A value expressed in dollars of the current period is called a nominal value. The $5 wage in 2001 and the $6 wage in 2011 are nominal wages.

To convert nominal values to real values, we divide by a price index. The real value for a given period is the nominal value for that period divided by the price index for that period. This procedure gives us a value in dollars that have the purchasing power of the base period for the price index used. Using the CPI, for example, yields values expressed in dollars of 1982–1984 purchasing power, the base period for the CPI. The real value of a nominal amount X at time t, Xt, is found using the price index for time t:

Equation 5.5

Real value of  Xt = Xt / price index at time  t

Let us compute the real value of the $6 wage for busing dishes in 2011 versus the $5 wage paid to your uncle in 2001. The CPI in 2001 was 177.1; in 2011 it was 224.9. Real wages for the two years were thus

Real wage in 2001 = $5 / 1.771 = $2.82

Real wage in 2011 = $6 / 2.249 = $2.67

Given the nominal wages in our example, you earned about 5% less in real terms in 2011 than your uncle did in 2001.

Price indexes are useful. They allow us to see how the general level of prices has changed. They allow us to estimate the rate of change in prices, which we report as the rate of inflation or deflation. And they give us a tool for converting nominal values to real values so we can make better comparisons of economic performance across time.