Price Indices &
Inflation
Learn how economists measure changes in the overall price level using the CPI and GDP deflator, and understand how inflation and deflation shape the economy.
What Is a Price Index?
A price index is a number that tracks the average price level of a specific basket of goods and services over time, relative to a base year. The base year always equals 100.
Why Inflation Matters
Inflation is a sustained increase in the general price level. It erodes purchasing power: each dollar buys fewer goods over time. Understanding inflation helps policymakers set interest rates and helps you interpret real wages.
Visualizing the Consumer Price Index
The CPI Formula
The Consumer Price Index compares the cost of a fixed market basket in a given year to its cost in the base year:
This formula uses fixed quantities from the base year. Prices change, but the basket stays the same: that is why the CPI is called a fixed-weight (Laspeyres) index.
Calculating the Inflation Rate
The inflation rate measures the percentage change in the price index from one period to the next:
The GDP Deflator
The GDP deflator is another price index. Unlike the CPI, it covers all domestically produced goods and services, not just consumer goods:
Because it uses current-year quantities (a Paasche index), the GDP deflator automatically updates its basket and avoids substitution bias, but it can understate inflation.
CPI vs. GDP Deflator
| CPI | GDP Deflator | |
|---|---|---|
| Basket | Fixed (base-year quantities) | Variable (current-year quantities) |
| Scope | Consumer goods and services only | All domestically produced goods |
| Imports | Included | Excluded |
| Index Type | Laspeyres | Paasche |
| Bias | Overstates inflation | Understates inflation |
Real vs. Nominal Values
Nominal values are expressed in current dollars. Real values adjust for inflation, showing purchasing power in base-year dollars:
This formula works for wages, GDP, interest rates, and any monetary measure. Always divide by the relevant price index and multiply by 100.
How to Calculate Step by Step
Example 1: Computing CPI
A market basket contains 10 pizzas and 5 textbooks. In the base year, a pizza costs \(\$10\) and a textbook costs \(\$40\). In the current year, a pizza costs \(\$12\) and a textbook costs \(\$50\).
Example 2: Inflation Rate
The CPI was 120 in 2022 and 126 in 2023. What was the inflation rate?
The general price level rose by \(5\%\) from 2022 to 2023. This tells us the rate of change of prices, not the level itself.
Example 3: Real Wages
A worker earns a nominal wage of \(\$60{,}000\). The CPI is 150 (base year = 100). What is the worker's real wage?
Example 4: GDP Deflator
Nominal GDP is \(\$22\) trillion and Real GDP is \(\$20\) trillion. Find the GDP deflator and the inflation rate if last year's deflator was 105.
The overall price level for domestic production rose by approximately \(4.76\%\).
Common Mistakes to Avoid
Key Formulas at a Glance
| Concept | Formula |
|---|---|
| CPI | \(\frac{\text{Cost}_{\text{current}}}{\text{Cost}_{\text{base}}} \times 100\) |
| Inflation Rate | \(\frac{\text{CPI}_{\text{new}} - \text{CPI}_{\text{old}}}{\text{CPI}_{\text{old}}} \times 100\) |
| GDP Deflator | \(\frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100\) |
| Real Value | \(\frac{\text{Nominal Value}}{\text{Price Index}} \times 100\) |
| Nominal Value | \(\frac{\text{Real Value} \times \text{Price Index}}{100}\) |
Question 1 of 5
A market basket costs \(\$200\) in the base year and \(\$230\) in the current year. What is the CPI for the current year?
Question 2 of 5
If the CPI was 140 last year and 147 this year, what is the inflation rate?
Question 3 of 5
Nominal GDP is \(\$18\) trillion and real GDP is \(\$15\) trillion. What is the GDP deflator?
Question 4 of 5
A worker's nominal salary is \(\$80{,}000\). The CPI is 160. What is the worker's real salary in base-year dollars?
Question 5 of 5
Which of the following is a key difference between the CPI and the GDP deflator?