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A word of warning: When a price index moves from, say, 107 to 110, the rate of inflation is not exactly 3%. Remember, the inflation rate is not derived by subtracting the index numbers, but rather through the percentage-change calculation. The precise inflation rate as the price index moves from 107 to 110 is calculated as (110 – 107) / 107 = 0.028 = 2.8%. When the base year is fairly close to 100, a quick subtraction is not a terrible shortcut to calculating the inflation rate—but when precision matters down to tenths of a percent, subtracting will not give the right answer.
Two final points about index numbers are worth remembering. First, index numbers have no dollar signs or other units attached to them. Although index numbers can be used to calculate a percentage inflation rate, the index numbers themselves do not have percentage signs. Index numbers just mirror the proportions found in other data. They transform the other data so that the data are easier to work with.
Second, the choice of a base year for the index number—that is, the year that is automatically set equal to 100—is arbitrary. It is chosen as a starting point from which changes in prices are tracked. In the official inflation statistics, it is common to use one base year for a few years, and then to update it, so that the base year of 100 is relatively close to the present. But any base year that is chosen for the index numbers will result in exactly the same inflation rate. To see this in the previous example, imagine that period 1, when total spending was $100, was also chosen as the base year, and given an index number of 100. At a glance, you can see that the index numbers would now exactly match the dollar figures, the inflation rate in the first period would be 6.5%, and so on.
Now that we see how indexes work to track inflation, the next module will show us how the cost of living is measured.
Watch this video from the cartoon Duck Tales to view a mini-lesson on inflation.
The price level is measured by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. The price level is often expressed in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. The rate of inflation is measured as the percentage change between price levels or index numbers over time.
The index number representing the price level changes from 110 to 115 in one year, and then from 115 to 120 the next year. Since the index number increases by five each year, is five the inflation rate each year? Is the inflation rate the same each year? Explain your answer.
The total price of purchasing a basket of goods in the United Kingdom over four years is: year 1=£940, year 2=£970, year 3=£1000, and year 4=£1070. Calculate two price indices, one using year 1 as the base year (set equal to 100) and the other using year 4 as the base year (set equal to 100). Then, calculate the inflation rate based on the first price index. If you had used the other price index, would you get a different inflation rate? If you are unsure, do the calculation and find out.
Sources for
[link] :
http://www.eia.gov/dnav/pet/pet_pri_gnd_a_epmr_pte_dpgal_w.htm
http://data.bls.gov/cgi-bin/surveymost?ap
http://www.bls.gov/ro3/apmw.htm
http://www.autoblog.com/2014/03/12/who-can-afford-the-average-car-price-only-folks-in-washington/
https://www.census.gov/construction/nrs/pdf/uspricemon.pdf
http://www.bls.gov/news.release/empsit.t24.htm
http://variety.com/2015/film/news/movie-ticket-prices-increased-in-2014-1201409670/
US Inflation Calculator. "Historical Inflation Rates: 1914-2013." Accessed March 4, 2015. http://www.usinflationcalculator.com/inflation/historical-inflation-rates/.
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