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AP Macroeconomics
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Table of Contents
Unit 2 Overview: Economic Indicators and the Business Cycle
2.1 Circular Flow and GDP
2.2 Limitations of GDP
2.3 Unemployment
2.4 Price Indices and Inflation
2.5 Costs of Inflation
2.6 Real vs Nominal GDP
2.7 Business Cycles

💶ap macroeconomics review

2.4 Price Indices and Inflation

Verified for the 2025 AP Macroeconomics exam•Citation:

Consumer Price Index—a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. (Source: investopedia.com). The basket of consumer goods that we are talking about is a sample of goods and services that are typically bought by your average household.

Defining Inflation

So far, we've looked at GDP, which shows production, and unemployment, which describes the labor force. Inflation is another important economic concept that measures the general level of prices in an economy over time. Inflation is usually measured by the percentage change in a price index, such as the Consumer Price Index (CPI) or the GDP deflator.

Inflation occurs when the general level of prices in an economy is rising. It is expressed as a percentage and represents the rate at which the general price level is increasing over time. For example, if the inflation rate is 3%, it means that the general level of prices in the economy is increasing at a rate of 3% per year.

Deflation is the opposite of inflation and occurs when the general level of prices in an economy is falling. Deflation is expressed as a negative percentage and represents the rate at which the general price level is decreasing over time.

Disinflation is a slower rate of inflation, or a slowing down of the rate at which the general price level is increasing. For example, if the inflation rate was previously 5% and it slows down to 3%, it would be considered disinflation.

Inflation, deflation, and disinflation are all important economic concepts that can have significant impacts on an economy. Inflation can affect the purchasing power of money, as prices for goods and services rise faster than wages or incomes. Deflation can also have negative effects, as it can lead to a decline in demand and a decrease in economic activity. Central banks and governments typically aim to keep inflation within a certain range, as too high or too low of an inflation rate can have negative impacts on the economy. For the United States, this is roughly 2%. We'll talk about how the government and economic policy-makers target these variables later in the course - get excited!

Here's a graph of what the inflation rate has been throughout the latter half of the 20th century. Note that in general, recessionary periods bring with it lower inflation. The exception to this is the recession in the 1970s. This is because the economy experienced stagflation, in which prices rose and the economy contracted. This was because of oil crises.

The Inflation Rate in the United States over time. Source: FRED (Federal Reserve Economic Data)

Price Indices and the CPI

A price index is a statistical measure that reflects the changes in the general level of prices for a basket of goods and services over time. Price indices are commonly used to measure inflation and deflation, as they provide a way to track changes in the general price level of an economy.

One common price index is the Consumer Price Index (CPI), which measures the changes in the prices of a basket of goods and services consumed by households. The CPI is calculated by the Bureau of Labor Statistics in the United States and is used to measure the changes in the cost of living over time.

The CPI is based on a market basket of goods and services that is representative of the purchases made by households. The market basket includes a wide range of goods and services, including food, housing, clothing, transportation, and medical care. The prices of these goods and services are collected and used to calculate the CPI.

To calculate the CPI, the Bureau of Labor Statistics collects price data for the goods and services in the market basket from a sample of retailers, service providers, and other sources. These prices are then used to calculate the cost of the market basket at a specific point in time, known as the base period. The CPI is then calculated by comparing the cost of the market basket in the current period to the cost of the market basket in the base period, and expressing the change as a percentage.

The CPI is used to measure the changes in the cost of living over time and is often used to adjust wages, Social Security payments, and other income for inflation. It is also used to make international comparisons of inflation rates and to inform policy decisions related to monetary policy.

One source of bias in the CPI is the substitution bias, which occurs when consumers switch to cheaper alternatives as the prices of certain goods and services rise. If the CPI does not take into account these substitutions, it may overstate the actual increase in the cost of living.

Practice Problems

How to Calculate the CPI

The CPI defines a base year in which all other index values are based on. At the base year, the value is 100, and all other numbers represent a percent increase or decrease from the base year. For example, a CPI of 110 implies that prices have risen 10% since the base year. To find the CPI for a given year, divide that market basket by the base year and multiply by 100 convert to a percent.

To calculate the inflation rate, just calculate the percent change in prices or in CPIs. Percent change is defined as (final - initial) / initial * 100. 

Formulas

Sample Problem

United States Market Basket - 2016

United States Market Basket - 2017

United States Market Basket - 2018

The first step in calculating either the CPI or the inflation rate is to figure out the value of each market basket. Once you have calculated the market basket, then you can figure out both the CPI for each year and the inflation rate from year to year.

To find the value of the market basket for each year, you simply multiply Price x Quantity for each good and then add all those amounts together. Let's use 2016 as the base year in this example.

Market Basket Value for 2016 = ($3 x 10) + ($2 x 10) + ($5 x 10) = $100

Market Basket Value for 2017 = ($3.25 x 10) + ($3.50 x 10) + ($5.25 x 10) = $120

Market Basket Value for 2018 = ($3.50 x 10) + (3.50 x 10) + (5.50 x 10) = $125

💡When calculating the CPI for the base year, you are always going to get a 100 as the answer. The reason for this is because you divide the value of the market basket for the base year by itself.

2016 CPI = ($100/$100) x 100 = 100

2017 CPI = ($120/$100) x 100 = 120

2018 CPI = ($125/$100) x 100 = 125

2016 to 2017 Inflation Rate = ((120-100)/100) x 100 = 20%

2016 to 2018 Inflation Rate = ((125-100)/100) x 100 = 25%

Key Terms to Review (15)

Base period: The base period is a specific time frame used as a reference point for measuring changes in economic indicators, particularly in the context of price indices and inflation. This period serves as a benchmark against which current prices and economic data are compared to assess how much prices have increased or decreased over time. Understanding the base period is crucial for analyzing inflation rates, as it helps in determining how far current price levels deviate from those in the base period.
Bureau of Labor Statistics: The Bureau of Labor Statistics (BLS) is a principal agency of the U.S. federal government that collects, analyzes, and disseminates essential information about labor economics, employment, and inflation. It plays a critical role in providing data that informs economic policy, such as tracking price indices and inflation rates, which are essential for understanding the overall health of the economy and making informed decisions about monetary policy.
Central Bank: A central bank is a national financial institution that manages a country's currency, money supply, and interest rates. It plays a crucial role in implementing monetary policy, stabilizing the economy, and serving as a lender of last resort to the banking sector. The central bank's actions significantly impact various economic factors, including inflation, exchange rates, and overall economic growth.
Consumer Price Index (CPI): The Consumer Price Index (CPI) is a measure that examines the average change over time in the prices paid by consumers for a basket of goods and services. It serves as a key indicator of inflation and reflects the cost of living, helping to assess economic stability and purchasing power.
Cost of living: Cost of living refers to the amount of money needed to maintain a certain standard of living, including expenses like housing, food, taxes, and healthcare. It’s a critical concept because it helps gauge how economic conditions impact individuals' financial well-being, especially in relation to income and inflation. Changes in the cost of living are often measured using price indices, which track the overall price changes of goods and services over time.
Disinflation: Disinflation refers to the reduction in the rate of inflation, indicating that while prices are still rising, they are doing so at a slower pace than before. This phenomenon is often observed during periods when central banks implement monetary policies aimed at stabilizing the economy, which can lead to decreased consumer spending and a tightening of the money supply. Disinflation is an important concept as it can influence price indices and impact economic growth and purchasing power.
GDP deflator: The GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. It reflects how much prices have changed in relation to a base year, allowing for the calculation of real GDP by removing the effects of inflation from nominal GDP. This makes it a crucial tool for understanding economic growth and inflation dynamics, as well as for analyzing short-run aggregate supply shifts.
Inflation Rate: The inflation rate is the percentage increase in the general price level of goods and services in an economy over a specified period, typically measured annually. This rate indicates how much prices have risen compared to a previous period, which is crucial for understanding economic health and influences various factors like purchasing power, interest rates, and GDP calculations.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates to achieve macroeconomic goals such as controlling inflation, managing employment levels, and stabilizing the currency. It influences economic activity by affecting how much money is available for businesses and consumers to spend and invest, which can also impact international trade and capital flows.
Price index: A price index is a statistical measure that indicates the relative change in the price level of a basket of goods and services over time. It serves as a crucial tool for measuring inflation, allowing economists and policymakers to assess how prices fluctuate in an economy. By tracking the price index, one can identify trends in purchasing power and cost of living, which are important for making informed economic decisions.
Purchasing Power: Purchasing power refers to the amount of goods and services that can be bought with a unit of currency. It is closely tied to the concept of inflation, as inflation can erode purchasing power by increasing prices, meaning that consumers can buy less with the same amount of money over time. Understanding purchasing power is essential for analyzing economic growth, inflation, and overall economic stability.
Real variables: Real variables are economic measures that have been adjusted for inflation, reflecting the true value of goods and services in constant dollars. By using real variables, economists can assess the actual purchasing power and economic performance without the distortions caused by changing price levels. This adjustment is crucial for comparing economic data over time and understanding the genuine growth or decline in an economy.
Recession: A recession is a significant decline in economic activity across the economy that lasts for an extended period, typically recognized when a country experiences two consecutive quarters of negative GDP growth. This downturn is often accompanied by rising unemployment, declining consumer spending, and reduced business investment, leading to a contraction in overall economic output. Understanding recessions is crucial as they are part of the natural business cycle and have widespread implications on price levels, fiscal policies, and the mechanisms used to stabilize the economy.
Stagflation: Stagflation is an economic condition characterized by the simultaneous occurrence of stagnant economic growth, high unemployment, and high inflation. This situation presents a challenging scenario for policymakers, as traditional tools to combat inflation can exacerbate unemployment and vice versa, making it difficult to achieve a balance in the economy.
Substitution bias: Substitution bias occurs when consumers change their purchasing habits in response to price changes, leading to a discrepancy in how inflation is measured. As prices of certain goods rise, consumers may substitute more expensive items with cheaper alternatives, which can distort the true cost of living and the accuracy of price indices. This bias highlights the limitations of traditional inflation measures, as they may not fully account for consumers’ behaviors in changing their consumption patterns.
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2.5 Costs of Inflation