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Calculating the Rate of Inflation
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The consumer price index (CPI) measures the change in prices of
yesterday’s goods and services relative to today’s dollar by holding
quantities constant.
The GDP deflator measures the purchasing power of yesterday’s dollar
relative to today’s basket of goods and services by holding prices constant
and using the current year quantities to calculate inflation.
Both measures calculate the rate of change in inflation, but because
different weights are used, they will generate different answers.
Suppose an economy produces only
two goods: food and clothing.
In year 0, we multiply the price and
quantity of food and the price and
quantity of clothing. Next we add
those numbers together to get the
economy’s total nominal GDP for that
year. Repeat the steps for year 1.
Next we will use the CPI to calculate
the rate of change in inflation.
Remember that the CPI is a monthly
measure of the basket of goods and
services that only households
purchase.
Because the CPI measures how price
levels have changed, we want to hold
the quantities constant for each good
from year 0 to year 1 to calculate real
GDP. Multiply year 1’s price and year
0’s quantity to find the real GDP for
year 1.
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We choose year 0 as our base year to
calculate the CPI. Because year 0 is
the base year, the CPI for that year will
be 100.
Divide real GDP in year 1 by the real
GDP in the base year and multiply by
100 to calculate the CPI for year 1.
The CPI for year 1 is 154.
Now that we have the CPIs for both
year 0 and year 1, we can now use the
equation on the left to calculate the
rate of change in prices. We can see
after multiplying the result by 100 that
prices have risen by 54%.
This percentage tells us that the basket
of food and clothing in year 0 costs
54% more in year 1.
Let’s now calculate inflation using the
GDP deflator. Remember that the
gross domestic product is the market
value of all goods and services
produced within a country in a given
period of time.
Recall our calculations of nominal GDP
as shown on the left. By holding prices
constant, we calculate the real GDPs
for year 0 and year 1.
Recall that the GDP deflator = (nominal
GDP/real GDP) • 100. Remember that
because year 0 is our base year, the
GDP deflator for that year is 100. We
calculate the GDP deflator for year 1 to
be 161.
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Copyright ã 2006, Thinkwell Corp. All Rights Reserved.
1188.doc –rev 11/07/2006
Using our formula again to calculate
the rate of change in inflation, we find
that inflation has risen 61% according
to the GDP deflator.
This means that year 1’s basket of
goods and services at year 1’s prices
costs 61% more than year 1’s basket
at year 0’s prices.
Consider the chart on the left. Using
the GDP deflator, we calculated a 61%
inflation rate, whereas the CPI yielded
a 54% inflation rate. Because we used
different weights to calculate these
inflation rates, the answers will be
different.
www.compasslearning.com
Copyright ã 2006, Thinkwell Corp. All Rights Reserved.
1188.doc –rev 11/07/2006