22.1 Tracking Inflation

Inflation affects everyone's wallet, but how do we measure it? Enter the basket of goods, a collection of everyday items used to track price changes over time. By comparing prices year to year, economists calculate inflation rates and their impact on our purchasing power.

Understanding inflation is crucial for making smart financial decisions. It affects wages, savings, and the overall economy. By tracking inflation rates, we can see how our money's value changes and adjust our spending and saving habits accordingly.

Measuring and Tracking Inflation

Basket of Goods

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• Representative sample of commonly purchased items includes goods and services from various categories (food, housing, transportation, healthcare, entertainment)
• Designed to reflect the spending habits of a typical consumer or household
• Prices of items in the basket are tracked over time to measure changes in the overall price level
  • Collected periodically (monthly, annually)
  • Basket remains relatively constant to ensure consistent comparisons across time periods
• Used to calculate the Consumer Price Index (CPI) measures the average change in prices paid by urban consumers for the basket of goods and services and is a commonly used measure of inflation

Inflation Rates

• Price index numbers measure the change in prices over time relative to a base year assigned a value of 100
  • Prices in subsequent years are expressed as a percentage of the base year price
• Calculate the price index for a given year: $Price \space Index = \frac{Current \space Year \space Price}{Base \space Year \space Price} \times 100$
• Inflation rate is the percentage change in the price index from one period to another: $Inflation \space Rate = \frac{Price \space Index_{Current \space Year} - Price \space Index_{Previous \space Year}}{Price \space Index_{Previous \space Year}} \times 100$
• Example calculation:
  • Base year (2010) price of a basket of goods: $100
  • Current year (2020) price of the same basket: $120
  • $Price \space Index_{2020} = \frac{120}{100} \times 100 = 120$
  • $Inflation \space Rate = \frac{120 - 100}{100} \times 100 = 20\%$

Impact on Wages and Income

• Inflation erodes the purchasing power of money as prices rise, each unit of currency buys fewer goods and services
• Nominal wages or income may increase during inflationary periods but are not adjusted for inflation
• Real wages or income account for the effect of inflation and are adjusted for changes in the price level: $Real \space Wage = \frac{Nominal \space Wage}{Price \space Index} \times 100$
• If nominal wages increase at a slower rate than inflation, real wages will decrease meaning that even with a higher nominal income, consumers can afford fewer goods and services
• To maintain purchasing power, nominal wages must increase at the same rate as inflation
• Unexpected inflation can redistribute income and wealth
  • Borrowers may benefit as they repay loans with money that has less purchasing power
  • Lenders may lose as the real value of the repayments decreases