Measuring Prices and Inflation

As we have seen in the last two chapters, a measure of the general price level is needed to convert nominal quantities to real quantities and to estimate the rate of inflation. We begin this chapter with the question, how can information about millions of prices in the economy be reduced into a simpler, more manageable index? First, we look at the main types of price indices. How are they calculated? What are the advantages and disadvantages of each type? We conclude with a discussion of the price indices most commonly used in the formulation and execution of economic policy. In Chapter 2, we used a price index , the GDP (implicit price) deflator, as the preferred measure of the general level of prices or the value of money. The GDP deflator is not the only price index. In this chapter we shall learn about a variety of price indices and how they are constructed. The GDP deflator in Chapter 2 served two purposes. First, we typically care about real rather than nominal quantities: real GDP, real consumption, real investment, real government expenditure. In Chapters 2 and 3 we saw that real GDP and its components are not observed directly. Rather, the national-income accountants must first measure market or nominal GDP in current dollars and then use a price index to convert it into real or constant dollars. Second, we sometimes care about how fast prices are changing. The growth rate of a price index, the rate of inflation, provides a measure.