Concern about changes in the price level has always dominated economic discussion. With inflation in the United States generally averaging only between 2% and 3% each year since 1990, it may seem surprising how much attention the behavior of the price level still commands. Yet inflation was a concern in 2004 when there was fear that the rising price of oil could trigger higher prices in other areas. Just the year before, when inflation fell below 2%, there was talk about the risk of deflation. That did not happen; prices continued rising. Inflation rose substantially in the first half of 2008, renewing fears about subsequent further increases. Just what are inflation and deflation? How are they measured? And most important, why do we care? These are some of the questions we will explore in this section.
Inflation is an increase in the average level of prices, and deflation is a decrease in the average level of prices. In an economy experiencing inflation, most prices are likely to be rising, whereas in an economy experiencing deflation, most prices are likely to be falling.
There are two key points in these definitions:
- Inflation and deflation refer to changes in the average level of prices, not to changes in particular prices. An increase in medical costs is not inflation. A decrease in gasoline prices is not deflation. Inflation means the average level of prices is rising, and deflation means the average level of prices is falling.
- Inflation and deflation refer to rising prices and falling prices, respectively; therefore, they do not have anything to do with the level of prices at any one time. “High” prices do not imply the presence of inflation, nor do “low” prices imply deflation. Inflation means a positive rate of change in average prices, and deflation means a negative rate of change in average prices.
Computing the Rate of Inflation or Deflation
The rate of inflation or deflation is the percentage rate of change in a price index between two periods. Given price-index values for two periods, we can calculate the rate of inflation or deflation as the change in the index divided by the initial value of the index, stated as a percentage:
Rate of inflation or deflation = Percentage change in index / Initial value of index
To calculate inflation in movie prices over the 2007–2008 period, for example, we could apply Equation 5.4 to the price indexes we computed for those two years as follows:
Movie inflation rate in 2008 = (1.06 – 1.00) / 1.00 = 0.06 = 6%
The CPI is often used for calculating price-level change for the economy. For example, the rate of inflation in 2007 can be computed from the December 2006 price level (2.016) and the December 2007 level (2.073):
Inflation rate = (2.073 – 2.016) / 2.016 = 0.028 = 2.8%