Price Indexes &
Aggregate Price
Level
Chapter 7
Price Indexes
 To measure the aggregate price level, economists
calculate the cost of purchasing a market basket.
 A price index is the ratio of the current cost of that
market basket to the cost in a base year, multiplied
by 100.
A Simple Year-to-Year Market
Basket Comparison
Basket of Goods
Prices
2003
2004
Expenditures
2003
2004
10 pairs of jeans
$20.00/pr. $25.00/pr.
$200
$200
12 flannel shirts
15.00/ea. 20.00/ea.
180
240
100 lbs. Apples
0.80/lb.
1.05/lb.
80
105
80 lbs. Oranges
1.00/lb.
1.00/lb.
80
80
$540
$675
Total Expenditures
Price index in 2003 
$675
X 100  125
$540
Calculating the Cost of a
Market Basket
Inflation Rate
• The inflation rate is the yearly
percentage change in a price index,
typically based upon Consumer Price
Index, or CPI, the most common
measure of the aggregate price level.
CPI
The consumer price index, or CPI, measures
the cost of the market basket of a typical
urban American family.
The Makeup of the Consumer
Price Index in 2004
Some Questions to Ask?
• Who is a typical consumer?
• Do we all consume the same stuff?
• Do different countries use different weights?
– How about different regions of the same country?
Price Effects
• Two basic lessons:
– Not all prices rise at the same rate during
inflation.
– Not everyone suffers equally from inflation.
Price Changes in 2000
Prices That Rose
(percent)
Gasoline
+28.5
Prices That Fell
(percent)
Coffee
–0.5
Lettuce
+9.5
Video rentals
–1.5
Airfares
+9.4
Women’s dresses
–6.9
Textbooks
+7.0
Oranges
–14.7
Cable TV
+4.8
Computers
–23.2
College tuition
+4.1
Average inflation rate: +3.4%
Is the CPI Biased
• The CPI is biased upward when new
products whose prices are falling are
left out of the market basket.
Biased
• The CPI is not a perfect measure of
inflation because an increase in price
may be caused by quality
improvements.
• There is no consensus on how large
a Bias (if any)!
The CPI, 1913–2004
Other Price Measures
• A similar index to CPI for goods
purchased by firms is the producer price
index.
• PPI responds to inflationary/deflationary
pressures more quickly than the CPI
Other Price Measures
• Economists also use the GDP deflator,
which measures the price level by
calculating the ratio of nominal to real
GDP.
• The GDP deflator for a given year is
100 times the ratio of nominal GDP to
real GDP in that year.
The CPI, the PPI, and the GDP
Deflator

The three different measures of inflation
usually move closely together. Each
reveals a drastic acceleration in the
inflation rate during the 1940s and the
1970s and a return to relative price
stability in the 1990s.
Political importance of CPI
• CPI plays an important and direct role
in most peoples lives so it is the most
politically sensitive index