2.4 Price Indices and Inflation

a. Define the consumer price index (CPI), inflation, deflation, disinflation, the inflation rate, and real variables. b. Explain how price indices can be used to calculate the inflation rate and to compare nominal variables over time periods. c. Calculate the CPI, the inflation rate, and changes in real variables.

• The consumer price index (CPI) measures the change in income a consumer would need in order to maintain the same standard of living over time under a new set of prices as under the original set of prices.
• The CPI measures the cost of a fixed basket of goods and services in a given year relative to the base year. Calculating the producer price index (PPI) is beyond the scope of the course and AP Exam.
• The inflation rate is determined by calculating the percentage change in a price index, such as CPI or the GDP deflator.
• Real variables, such as real wages, are the nominal variables deflated by the price level.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.

Define the shortcomings of the CPI as a true measure of inflation.

• The CPI as a measure of inflation has some shortcomings, such as substitution bias, causing it to overstate the true inflation rate.
• Enduring understanding MEA-1: An economy’s performance can be measured by different indicators such as gross domestic product (GDP), the inflation rate, and the unemployment rate.