The Price Level and Inflation: Changes in the Price Level

Changes in the Price Level You should always keep in mind that the official inflation rate is a measure of the average rate of change in the prices of a broad aggregate of products. For example, in 1986 when the official inflation rate was 1.9 percent measured by the percentage change in CPI, energy prices fell by 19.7 percent, which helped pull the average of all prices down. However, food prices rose by 3.7 percent that year, and the price of medical care rose by 7.7 percent. The economy rarely experiences pure inflation, during which the prices of all goods rise by the same percentage over the year. The change in the relative price of a good is a change in its price relative to the prices of an average of all goods. If the economy experienced pure inflation, there would be no changes in the relative prices of goods because the price of every good would rise by the same percentage. Under pure inflation, the price of any one good does not change more or less than the average rate. This means that over the year any particular good does not become any cheaper or more expensive relative to other goods than it was at the beginning of the year. Pure inflation therefore does not provide any incentive for consumers to substitute one good for another in their budget, nor does it change the profitability for sellers of one good rather than another. On the other hand, changes in the relative prices of goods in the economy are signals that provide incentives to adapt to changing conditions. The GNP Deflator The CPI is the best measure of the price level for determining changes in the cost of living for typical urban households in the United States. Sometimes, however, we want to use a broader measure of the price level to measure the effects of inflation on producers' incentives to supply all goods and services. Remember, GNP does not only include consumption goods it also includes goods and services produced for use as final products by businesses, governments, and foreign buyers who demand our exports. A broader index of inflation would include the effects of changes in the prices of all investment goods, government purchases, and net exports. The GNP deflator is the ratio of nominal GNP to real GNP (multiplied by 100); it is an index of the average of the prices used to deflate nominal GNP. Remember that nominal GNP measures aggregate production of final products valued at their current market prices. Real GNP measures the value of aggregate production of final products valued at base year prices. The Department of Commerce currently uses 1982 as the base year in calculating real GNP. The GNP deflator is therefore: Implict GNP deflator = (Nominal GNP/Real GNP) 100 For example, in 1989 the GNP deflator stood at 126.3, which implies that, on average, final products that was priced at $100 in 1982 would have been priced at $126.30 in 1989. The aggregate of products used to compute the GNP deflator differs from that used to compute the CPI. Imported products are not part of GNP because they are produced in foreign nations. Therefore, a change in the price of a VCR imported from Japan will have no impact on the GNP deflator. However, the price change will affect the CPI if the VCR was purchased by a typical urban family. In 1988 when the prices of imported items rose sharply, the CPI increased to reflect such price increases but the GNP deflator did not. The GNP deflator will also change with the mix of products in current GNP. Unlike the CPI, the GNP deflator does not measure the change in the cost of a standard market basket of a given combination of products.