Page 185 - Krugmans Economics for AP Text Book_Neat

typical consumer bought 200 oranges, 50 grapefruit, and
100 lemons over the course of a year.
Table 15.1 shows the pre -frost and post -frost costs of
this market basket. Before the frost, it cost $95; after the
frost, the same basket of goods cost $175. Since $175/$95 = © PhotoAlto/Alamy
1.842, the post -frost basket costs 1.842 times the cost of the
pre- frost basket, a cost increase of 84.2%. In this example, the av-
erage price of citrus fruit has increased 84.2% since the base year as a result of the frost,
where the base year is the initial year used in the measurement of the price change. Section 3 Measurement of Economic Performance

table 15.1

Calculating the Cost of a Market Basket
Pre - frost Post - frost
Price of orange $0.20 $0.40
Price of grapefruit 0.60 1.00
Price of lemon 0.25 0.45
Cost of market basket (200 × $0.20) + (200 × $0.40) +
(200 oranges, 50 grapefruit, (50 × $0.60) + (50 × $1.00) +
100 lemons) (100 × $0.25) = $95.00 (100 × $0.45) = $175.00

Economists use the same method to measure changes in the overall price level: they
track changes in the cost of buying a given market basket. Working with a market basket
and a base year, we obtain what is known as a price index, a measure of the overall price
level. It is always cited along with the year for which the aggregate price level is being
measured and the base year. A price index can be calculated using the following formula:

(15-1) Price index in a given year = Cost of market basket in a given year × 100
Cost of market basket in base year

In our example, the citrus fruit market basket cost $95 in the base year, the year before the
frost. So by applying Equation 15-1, we define the price index for citrus fruit as (cost of
market basket in the current year/$95) × 100, yielding an index of 100 for the period be-
fore the frost and 184.2 after the frost. You should note that applying Equation 15-1 to
calculate the price index for the base year always results in a price index of (cost of market
basket in base year/cost of market basket in base year) × 100 = 100. Choosing a price index
formula that always normalizes the index value to 100 in the base year avoids the need to
keep track of the cost of the market basket, for example, $95, in such-and-such a year.
The price index makes it clear that the average price of citrus has risen 84.2% as a conse-
quence of the frost. Because of its simplicity and intuitive appeal, the method we’ve just
described is used to calculate a variety of price indexes to track average price changes
among a variety of different groups of goods and services. Examples include the consumer
price index and the producer price index, which we’ll discuss shortly. Price indexes are also the
basis for measuring inflation. The price level mentioned in the inflation rate formula in
Module 14 is simply a price index value, and the inflation rate is determined as the annual
percentage change in an official price index. The inflation rate from year 1 to year 2 is thus
calculated using the following formula, with year 1 and year 2 being consecutive years.

(15-2) Inflation rate = Price index in year 2 − Price index in year 1 × 100
Price index in year 1 A price index measures the cost of
purchasing a given market basket in a given
Typically, a news report that cites “the inflation rate” is referring to the annual percent year. The index value is normalized so that it
change in the consumer price index. is equal to 100 in the selected base year.

module 15 The Measurement and Calculation of Inflation 143