202-T&C-4(1) - 1 Econ 202 Terms and Concepts 4 PRICE...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Econ 202: Terms and Concepts 4: PRICE INDICES and INFLATION INFLATION Inflation is an increase in the general price level, affecting all prices at the same time. It is distinct from the changes in relative prices that occur when factor scarcity changes or when consumer choices change. Inflation occurs when the supply of money to the economy grows faster than the production of real goods and services. We measure inflation using a price index . A base year is selected arbitrarily and its index number is set equal to 100. Prices in subsequent and previous years are then given index numbers that indicate their growth or decline relative to prices in the base year. Because inflation affects all prices in the economy, several price indices exist that show the inflation in specific sector of the economy, for example the consumer price index , which shows inflation in 200 categories of consumer good that a typical household uses routinely. A price index is developed by selecting a basket of goods that is representative of the sector of the economy we wish to measure, like the 200 categories of consumer goods mentioned above. A base year is chosen, and its index number is set equal to 100. The basket of goods is measured at the prices that prevail in the base year. This is the nominal value of those goods in the base year. The quantity in each category is weighted to reflect its proportion to the whole basket. /08/remembering-milton-friedman Milton Friedman 1912-2006 The Economist who is most famous for his work on inflation is Nobel Laureate Milton Friedman. He asserted the view that "inflation is a purely monetary phenomenon," in other words, caused exclusively by improper growth of the money supply. That view is almost universally accepted today, though as founder of the "Monetarist School" of thought he was at the center of fierce controversy during his lifetime. His signature book is Monetary History of the United States , co-authored with Anna Jacobson Schwartz and published in 1963. 1
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
That same basket of goods is then measured in the prices of subsequent years, so that the quantity is always the same and only the prices are changing. Those nominal values in subsequent years are then expressed as a ratio over the nominal value of the base year, and multiplied by 100 to convert the ratio to an index number. The table on the following page shows a price index for consumer goods that uses 2004 as its base year. The Consumer Price Index is not a Cost of Living Index, but a CoL Index can be determined from the CPI. There is debate about the extent to which substitution effects (choosing cheaper alternatives) should be taken into account to lower the CoL Index below the CPI. Year 2004 2005 2006 2007 Nominal value $9.28 $9.92 $10.56 $11.04 Index No. 100 Index Number in 2005 = ($9.92) ÷ $( 9.28 ) x 100 = 106.9 Year 2004 2005 2006 2007 Index No. 100 106.9 Index Number in 2006 = ($10.56) ÷ $( 9.28 ) x 100 = 113.79 Year 2004 2005 2006 2007 Index No. 100 106.9 113.79 Index Number in 2006 = ($11.04) ÷ $( 9.28 ) x 100 = 118.97 Year 2004 2005 2006 2007 Index No. 100 106.9 113.79 118.97 Note that in the ratio used to determine the relative nominal values, the denominator is always the base year. This is not an annual growth rate but an index, so the denominator is not the preceding
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern