Page 177 - Krugmans Economics for AP Text Book_Neat

would become 2 new dollars an hour, and so on. This would bring the overall U.S.
The real wage is the wage rate divided
price level back to about what it was when John F. Kennedy was president.
by the price level.
So would everyone be richer as a result because prices would be only one-seventh as
Real income is income divided by the
high? Of course not. Prices would be lower, but so would wages and incomes in general.
price level.
If you cut a worker’s wage to one-seventh of its previous value, but also cut all prices to
The inflation rate is the percent change
one-seventh of their previous level, the worker’s real wage—the wage rate divided by the
per year in a price index—typically the
price level—doesn’t change. In fact, bringing the overall price level back to what it was
consumer price index.
during the Kennedy administration would have no effect on overall purchasing power,
because doing so would reduce income exactly as much as it reduced prices. Conversely, Section 3 Measurement of Economic Performance
the rise in prices that has actually taken place since the early 1960s hasn’t made America
poorer, because it has also raised incomes by the same amount: real income—income
divided by the price level—hasn’t been affected by the rise in overall prices.
The moral of this story is that the level of prices doesn’t matter: the United States
would be no richer than it is now if the overall level of prices was still as low as it was in
1961; conversely, the rise in prices over the past 45 years hasn’t made us poorer.
. . . But the Rate of Change of Prices Does

The conclusion that the level of prices doesn’t matter might seem to imply that the in-
flation rate doesn’t matter either. But that’s not true.
To see why, it’s crucial to distinguish between the level of prices and the inflation rate.
In the next module, we will discuss precisely how the level of prices in the economy is
measured using price indexes such as the consumer price index. For now, let’s look at
the inflation rate, the percent increase in the overall level of prices per year. The infla-
tion rate is calculated as follows:

Inflation rate = Price level in year 2 − Price level in year 1 × 100
Price level in year 1

Figure 14.1 highlights the difference between the price level and the inflation rate in
the United States since 1969, with the price level measured along the left vertical axis
and the inflation rate measured along the right vertical axis. In the 2000s, the overall

figure 14.1

The Price Level versus the Price Inflation
Inflation Rate, 1969–2009 level rate
Over the past 40 years, the price level has 250 16%
continuously gone up. But the inflation rate— Inflation rate 14
the rate at which consumer prices are
200 12
rising—has had both ups and downs.
Source: Bureau of Labor Statistics. 10
150 Price level 8
6
100 4
2
50 0
–2
–4
1969 1970 1980 1990 2000 2009

Year

module 14 Inflation: An Overview 135