# sec_4 - PAM 2000 Section Handout 4 TA Romita Mukherjee 1...

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PAM 2000: Section Handout 4 TA : Romita Mukherjee February 24, 2009 1 Price Index - A Primer (1) Most commonly used price index is the Consumer Price Index (CPI) (2) A price index looks at how much it costs (i.e. how much income is needed) to buy a certain bundle of goods now versus in a “base year” (3) Example: Consider only two goods: Oranges and Tomatoes Q 1 o - Quantity of oranges purchased in year 1 Q 2 o - Quantity of oranges purchased in year 2 P 1 o - Price of oranges in year 1 P 2 o - Price of oranges in year 2 Q 1 t - Quantity of tomatoes purchased in year 1 Q 2 t - Quantity of tomatoes purchased in year 2 P 1 t - Price of tomatoes in year 1 P 2 t - Price of tomatoes in year 2 So the amount of income it takes to buy the combination of oranges and tomatoes in year 1 is: Y 1 = P 1 o Q 1 o + P 1 t Q 1 t The amount of income it takes to buy the combination in year 2 is: Y 2 = P 2 o Q 2 o + P 2 t Q 2 t 1

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(4) Now suppose, bundle is fixed at year 1 bundle. Then rate of inflation is how much more income it takes to buy the same bundle in year 2 relative to year 1 (note that Qs are from year 1, the base year).
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