MacroeconomicsI_working_version (1)

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Chapter 9
We speak about inflation when the general level of prices rises. When the price level
increases, some prices may not rise, even in case of rapid inflation. Some prices may be
relatively constant and others falling. One of the problems of inflation, as we will examine
later in the chapter, is that prices doesn’t rise evenly.
Inflation denotes a rise in the general level of prices. The rate of inflation is the rate of
change of the general price level and is measured as follows:
price level
(year t)
–
price level
(year t-1)
Rate of inflation (year t) =
price level (year t - 1)
But how do we measure the “price level“ that is involved in the definition of inflation?
Conceptually, the price level is measured as the weighted average of the goods and services
in an economy. In practise, we measure the overall price level by constructing price
indexes, which are averages of consumer or producer prices.
Deflation is the opposite of inflation. Deflation occurs when the general level of prices is
decreasing. Such cases happened very rarely in the late twentieth century.
Disinflation is a related term, which denotes a decline in the rate of inflation.
9.1. Measurement of Inflation
We measure inflation by price-index numbers. A price index is a weighted average of the
prices of a number of goods and services. To create such index we must assign a weight to
each price by economic importance of the good. The most important price indexes include
the consumer price index, the GDP deflator, and the producer price index.
Consumer Price Index (CPI). This index, often called CPI, is the most widely used
measure of inflation. Consumer price index measures inflation of a market basket including
most often purchased consumer goods and services such as food, clothing, housing,
transportation, education, medical care and others.
As we have explained above, the price index is constructed by weighting each price
according to the economic importance of the commodity in the basket. In the case of CPI,
each item in the basket obtains a fixed weight proportionally to its relative importance in
consumer expenditure budgets.
GDP deflator. The GDP deflator refers to price of all component of GDP (including
consumption, gross investment, government purchases, and net exports), because it is
counted as a ratio of nominal GDP to real GDP. GDP deflator is a variable-weight index
weighting prices by the current-period quantities, which also differ it from CPI. There are
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