Page 184 - Krugmans Economics for AP Text Book_Neat

What you will learn
in this Module:

• How the inflation rate is Module 15
measured
• What a price index is and
how it is calculated The Measurement and
• The importance of the
consumer price index and
other price indexes Calculation of Inflation

Price Indexes and the Aggregate Price Level
The aggregate price level is a measure of
In the summer of 2008, Americans were facing sticker shock at the gas pump: the price
the overall level of prices in the economy.
of a gallon of regular gasoline had risen from about $3 in late 2007 to more than $4 in
A market basket is a hypothetical set of
most places. Many other prices were also up. Some prices, though, were heading down:
consumer purchases of goods and services.
the prices of some foods, like eggs, were coming down from a run-up earlier in the year,
and virtually anything involving electronics was also getting cheaper. Yet practically
everyone felt that the overall cost of living seemed to be rising. But how fast?
Clearly there was a need for a single number summarizing what was happening to
consumer prices. Just as macroeconomists find it useful to have a single number to rep-
resent the overall level of output, they also find it useful to have a single number to rep-
resent the overall level of prices: the aggregate price level. Yet a huge variety of goods
and services are produced and consumed in the economy. How can we summarize the
prices of all these goods and services with a single number? The answer lies in the con-
cept of a price index—a concept best introduced with an example.

Market Baskets and Price Indexes
Suppose that a frost in Florida destroys most of the citrus harvest. As a result, the price
of oranges rises from $0.20 each to $0.40 each, the price of grapefruit rises from $0.60
to $1.00, and the price of lemons rises from $0.25 to $0.45. How much has the price of
citrus fruit increased?
One way to answer that question is to state three numbers—the changes in prices for
oranges, grapefruit, and lemons. But this is a very cumbersome method. Rather than
having to recite three numbers in an effort to track changes in the prices of citrus fruit,
we would prefer to have some kind of overall measure of the average price change.
To measure average price changes for consumer goods and services, economists
track changes in the cost of a typical consumer’s consumption bundle—the typical basket
of goods and services purchased before the price changes. A hypothetical consump-
tion bundle, used to measure changes in the overall price level, is known as a market
basket. For our market basket in this example we will suppose that, before the frost, a

142 section 3 Measurement of Economic Performance