Inflation

The old saying tells us that "if it isn't one darn thing, it's another," and that's true enough in economics. Recessions and unemployment are trouble enough, but many people in the modern world see a danger in too much prosperity. The danger is inflation.

Inflation is defined as an increase in the average price level in the economy. Thus, if the price of each good or service in the economy were to rise by 5% from one year to the next, we could say without hesitation that the average price level has risen by 5%, and there has been 5% inflation. But, in general, prices do not all rise at the same rate -- some rise rapidly, some rise slowly, and some prices even drop. Thus, we express the overall price level by a price index, that is, an average of these different rising and falling prices. But a simple average won't do. Some prices are more important than others. In the economy of the 1990's computers are more important than buggy-whips, so it doesn't make sense to add the price of computers to the price of buggy-whips and divide by two. Instead we use a weighted average with weights that reflect the importance of the different products in production. Since a lot more computers are produced than buggy-whips, we would give computers a heavier weight. Such a weighted index of prices is known as a "price index.

The best known price index is the Consumer Price ("cost of living") Index. The abbreviation CPI is often used for the Consumer Price Index. The consumer price index measures the average price of goods consumed by urban wage- earners. That is, the consumer price index is a weighted average in which the weights reflect the spending of urban wage-earners.

However, there are other price indices. Another important price index is the GDP deflator. The GDP deflator measures the average price of all of the Gross National Product. That is, the weights for the GDP deflator reflect the share of each good in the Gross Domestic Product. There could also be other price indices. Which is right? That depends on your purposes. If you want to gauge the purchasing power of the worker's dollar, then the consumer price index is probably best -- that's the purpose it was designed for. However, if you need to estimate the purchasing power of the dollar for all sorts of goods and services, including investment goods, the consumer price index doesn't do that, and the Gross Domestic Product Deflator is probably your best choice.

Inflation is measured as a percentage change in the price index. Thus 5% inflation this year means that a price index is 1.05 times as large as last year.

Base Year