KW_Macro_Ch_07_Sec_04_Price_Indexes_and_the_Aggregate_Price_Level

KW_Macro_Ch_07_Sec_04_Price_Indexes_and_the_Aggregate_Price_Level

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>> Tracking the Macroeconomy Section 4: Price Indexes and the Aggregate Price Level chapter 7 As we noted in Chapter 6, both inflation and deflation can pose problems for the economy. For that reason, we must have a way of measuring changes in the econo- my’s overall price level over time. The aggregate price level, a single number, is sup- posed to be a measure of the overall price level. But a huge variety of goods and services are produced and consumed within the economy. How can we summarize the prices of all these goods and services with a single number? The answer lies in the concept of a price index —a concept best introduced with an example. Market Baskets and Price Indexes Suppose that a frost in Florida destroys most of the citrus harvest. As a result, the price of oranges rises from \$0.20 each to \$0.40 each, the price of grapefruit rises from \$0.60 to \$1.00, and the price of lemons rises from \$0.25 to \$0.45. How much has the price of citrus fruit increased?

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One way to answer that question is to state three numbers, the changes in prices for oranges, grapefruit, and lemons. But this a very cumbersome method. Rather than having to recite three numbers every time someone asks what has happened to the prices of citrus fruit, we would prefer to have some kind of overall measure of the average price increase. Economists measure average price changes for consumer goods and services by ask- ing how much more or less a typical consumer would have to spend to buy his or her previous consumption bundle —the typical basket of goods and services purchased before the price changes. Suppose that before the frost a typical consumer bought 200 oranges, 50 grapefruit, and 100 lemons over the course of a year. The average indi- vidual might change that pattern of consumption after the price changes caused by the frost. But we can still ask how much it would cost if he or she were to buy the same mix of fruit. A hypothetical consumption bundle, used to measure changes in the overall price level, is known as a market basket. Table 7-3 shows the pre-frost and post-frost cost of the market basket. Before the frost, it cost \$95. After the frost, the same bundle of goods cost \$175. Because \$175/\$95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost CHAPTER 7 SECTION 4: PRICE INDEXES AND THE AGGREGATE PRICE LEVEL 2 A market basket is a hypothetical set of consumer purchasesof goods and services. TABLE 7-3 Calculating the Cost of a Market Basket Pre-frost Post-frost Price of orange \$0.20 \$0.40 Price of grapefruit \$0.60 \$1.00 Price of lemon \$0.25 \$0.45 Cost of market basket (200 × \$0.20) + (200 × \$0.40) + (200 oranges, 50 grapefruit, (50 × \$0.60) + (50 × \$1.00) + 100 lemons) (100 × \$0.25) = \$95.00 (100 × \$0.45) = \$175.00
basket, an increase in cost of 84.2%. So, in this case, we would say that the average price of citrus fruit increased 84.2% since the base year as a result of the frost.

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KW_Macro_Ch_07_Sec_04_Price_Indexes_and_the_Aggregate_Price_Level

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