Source: Prin Macroeconomics, University of Florida
Difficulty: Introductory Prerequisites: Familiarity with GDP and labour market basics (see companion notes on GDP, Labour Markets, and Unemployment Types).
Tags: inflation, deflation, hyperinflation, price level, Consumer Price Index, CPI, core CPI, base year, fixed basket, inflation rate, CPI calculation, new goods bias, quality improvement bias, commodity substitution bias, outlet substitution bias, real wages, purchasing power
After learning how to measure output (GDP) and employment, the next question is: what is happening to prices? Inflation is one of the most politically visible economic phenomena, and misunderstanding it leads to poor policy conclusions. This material covers what inflation is (and what it is not), how it is measured through the CPI, how to calculate the inflation rate from CPI data, and why the CPI systematically overstates true inflation. If you are coming in cold, the key prerequisite concept is that economists care about rates of change, not just levels, and that distinction runs through everything here.
Inflation is the rate at which the overall price level rises over time, not the same thing as prices being high. The Consumer Price Index (CPI) measures it by tracking the cost of a fixed basket of goods. Economists prefer moderate, predictable inflation (around 2%) because it supports planning and avoids deflation. The CPI has four known biases that cause it to overstate inflation by roughly 0.5 to 1 percentage point.
Price level
The average of all prices for goods and services in the economy at a given time, expressed as a single number. Think of it as a snapshot of how expensive things are right now.
Inflation
The rate at which the price level increases over time. In simple terms, inflation is about how fast prices are climbing, not how high they already are.
Deflation
A decrease in the overall price level, meaning prices across the economy are falling. This is often associated with economic downturns and can trigger a cycle of reduced spending and stagnation.
Hyperinflation
Extremely high inflation, typically defined as a monthly inflation rate of 50% or more. At this level, money loses value so rapidly that the economy can break down entirely (think: people using wheelbarrows of cash to buy bread).
Consumer Price Index (CPI)
The most common measure of the U.S. price level. It tracks the average price of a fixed basket of goods and services purchased by a typical urban family of four. The CPI is an index number with no units, scaled so that the base year (e.g. 1982) equals 100.
Base year
The reference year against which all CPI values are compared. Setting the base year's CPI to 100 makes it straightforward to see how much prices have changed. A CPI of 375 means prices are 3.75 times what they were in the base year.
Fixed basket of goods
The specific set of goods and services whose prices the CPI tracks. The basket is held constant year to year so that changes in the CPI reflect price changes only, not shifts in what people buy. It is updated every 6 to 8 years to swap out obsolete items.
Core CPI
A variant of the CPI that excludes food and energy prices because those categories are highly volatile. Core CPI gives a clearer view of long-term inflation trends by stripping out short-term noise from weather events, oil shocks, and similar disruptions.
Inflation rate
The percentage change in the CPI from one period to the next. This is the number that tells you how much faster prices are rising compared to the previous period.
Real wages
Wages adjusted for inflation. When prices rise faster than nominal wages, real wages fall and workers can buy less with the same pay cheque.
Purchasing power
The quantity of goods and services a unit of currency can buy. Inflation erodes purchasing power; deflation increases it.
"Prices are high" describes a level at a specific moment. "Inflation" describes a rate of change over time.
Controlling inflation means slowing the growth of prices. It does not necessarily mean bringing prices back down to where they were.
Economists generally prefer moderate, predictable inflation (around 2%) because it allows households and firms to plan contracts, wages, and investments with confidence.
Predictability: When inflation is steady and expected, long-term contracts, wages, and investment returns can be set sensibly. Surprises are the problem, not inflation itself.
Deflation avoidance: A low positive inflation rate provides a buffer against deflation. Deflation discourages spending (why buy today if it will be cheaper tomorrow?) and can spiral into economic stagnation.
Monetary policy room: A steady inflation target gives central banks a lever to work with. If inflation is already at zero, the central bank has less room to cut real interest rates during a downturn.
Income redistribution from employees to employers: When prices rise unexpectedly, wages tend to lag behind. Workers lose purchasing power while employers benefit from paying less in real terms.
Wealth redistribution from lenders to borrowers: Borrowers repay loans with money that is worth less than when they borrowed it. Lenders receive less real value back. This is why unexpected inflation favours debtors.
Diminished value of savings: Cash and fixed-income assets lose real value. A saver who locked in a 3% return while inflation runs at 5% is losing ground.
Resource diversion: Businesses and governments spend time and money predicting and hedging against inflation instead of doing productive work. The analogy from the lecture: it is like rebuilding after a natural disaster, effort spent addressing a problem that need not exist.
Reduced affordability: When wages do not keep pace with inflation, real purchasing power declines and everyday goods become harder to afford.
The CPI tracks the cost of a fixed basket of goods and services bought by a typical urban family of four.
It is an index number, not a dollar amount. The base year is set to 100; all other years are expressed relative to that.
The basket is held constant between updates so that any change in the CPI reflects price movement only, not changes in consumption habits.
The basket is updated surgically every 6 to 8 years to add new products and remove obsolete ones (e.g. streaming services replaced VCRs).
Core CPI strips out food and energy because their prices swing sharply due to weather, geopolitics, and seasonal patterns.
Policymakers often look at core CPI for a cleaner signal of underlying inflation trends.
CPI formula:
CPI = (Cost of basket in current year / Cost of basket in base year) × 100
Inflation rate formula:
Inflation Rate = ((CPI current – CPI previous) / CPI previous) × 100%
Worked example (from the lecture):
Basket: 100 arepas + 75 empanadas per year.
Year | Arepa price | Empanada price | Basket cost |
|---|---|---|---|
2022 | $2.00 | $1.00 | $275.00 |
2023 | $2.20 | $1.10 | $302.50 |
2024 | $2.50 | $1.20 | $340.00 |
Base year: 2022.
CPI 2022: ($275 / $275) × 100 = 100
CPI 2023: ($302.50 / $275) × 100 ≈ 110
CPI 2024: ($340 / $275) × 100 ≈ 124
Inflation rates:
2022 to 2023: (110 – 100) / 100 × 100% = 10%
2023 to 2024: (124 – 110) / 110 × 100% ≈ 12.7%
The CPI tends to overstate the true inflation rate by approximately 0.5 to 1 percentage point. Four biases are responsible:
New products launch at high prices and then fall rapidly as production scales up.
The CPI only adds new goods to the basket after their prices have already dropped, missing the high-to-low transition and recording only the lower prices going forward.
Result: the index overstates inflation by not capturing the effective price decline consumers experienced.
Products improve over time (a phone today does far more than a phone ten years ago).
The CPI counts the entire price increase as inflation, even when part of it reflects genuinely better quality.
Result: the measured inflation rate is higher than the "same-quality" inflation rate.
When the price of one good rises, consumers switch to cheaper alternatives (chicken instead of beef, for instance).
The fixed basket cannot reflect these substitutions, so it continues pricing the original, now more expensive, goods.
Result: the CPI overstates the cost increase that consumers actually experience.
Consumers shift purchases to lower-priced outlets: big-box retailers, online shops, discount stores.
The CPI traditionally collects prices from a fixed set of retailers and misses these savings.
Result: the index records higher prices than consumers are paying in practice.
The CPI is the basis for Social Security cost-of-living adjustments (COLAs), inflation-indexed bonds (TIPS), and tax bracket adjustments. Because CPI overstates inflation, these adjustments tend to be slightly more generous than the "true" change in living costs. The Boskin Commission (1996) first estimated this overstatement at about 1.1 percentage points, and methodological improvements have narrowed it, but the bias persists.
Students often confuse "prices are high" with "inflation is high." Prices can be high and stable (low inflation) or low and rising fast (high inflation). The rate of change is what matters.
Students often think controlling inflation means making prices go back down. It means slowing the rate of increase. After a period of inflation, the new higher price level typically stays.
Students sometimes assume the CPI basket changes every year. It does not; it is held fixed and only updated every 6 to 8 years specifically so that year-to-year changes reflect price movements.
Students often forget that the CPI overstates inflation. On an exam, if asked whether the CPI is a perfect measure, the answer is no, and you should be able to name and explain the four biases.
⚠️ Be able to calculate CPI from basket costs and a base year, and then derive the inflation rate from two CPI values. The arepa/empanada example is the kind of problem that appears on exams.
⚠️ Know the distinction between inflation (rate of change) and price level (absolute level). This is a favourite conceptual question.
⚠️ Be able to name and explain all four CPI biases: new goods, quality improvement, commodity substitution, and outlet substitution. Know that together they overstate inflation by roughly 0.5 to 1 percentage point.
⚠️ Understand why economists prefer moderate, expected inflation (predictability, deflation avoidance, monetary policy flexibility) and be able to list the consequences of unexpected inflation (redistribution from workers to employers, from lenders to borrowers, erosion of savings, resource diversion).
⚠️ Know what core CPI is and why food and energy are excluded (volatility).
True or False: Inflation means prices are high. (False. Inflation is the rate at which prices are rising, not the level of prices.)
Fill in the blank: The CPI measures the cost of a _______ basket of goods purchased by a typical urban family of four. (Fixed)
True or False: Core CPI includes food and energy prices. (False. Core CPI excludes them due to their volatility.)
Fill in the blank: The CPI overstates inflation by approximately _______ percentage point(s). (0.5 to 1)
True or False: When unexpected inflation occurs, borrowers benefit at the expense of lenders. (True.)
Q: What is the difference between inflation and prices being high?
A: Prices being high refers to the absolute level of prices at a given moment. Inflation refers to the rate at which that level is increasing over time. Prices can be high with low inflation (stable but expensive) or low with high inflation (cheap but rising fast).
Q: Given a CPI of 150 last year and 159 this year, what is the inflation rate?
A: (159 – 150) / 150 × 100% = 6%.
Q: Name and briefly explain the four biases that cause the CPI to overstate inflation.
A: (1) New goods bias: new products enter the basket after their prices have already fallen. (2) Quality improvement bias: price increases due to better quality are counted as inflation. (3) Commodity substitution bias: the fixed basket does not reflect consumers switching to cheaper alternatives. (4) Outlet substitution bias: the CPI misses savings from consumers shopping at discount or online retailers.
Q: Why do economists prefer a moderate, positive inflation rate rather than zero inflation?
A: A moderate rate (around 2%) allows for predictable planning of contracts and wages, provides a buffer against deflation (which discourages spending), and gives central banks room to lower real interest rates during downturns.
Q: Unexpected inflation redistributes wealth from lenders to borrowers. Explain why.
A: Borrowers repay their loans with money that has less purchasing power than when they borrowed it. The lender receives the same nominal amount but can buy less with it. In real terms, the borrower has paid back less than expected, benefiting at the lender's expense.
Q: Why is the CPI basket held fixed rather than updated every year?
A: Holding the basket constant ensures that changes in the CPI reflect price changes only, not changes in what consumers are buying. If the basket changed annually, a rise in the index might reflect new, more expensive products entering the basket rather than a genuine increase in the cost of living.
The CPI and inflation rate connect directly to monetary policy (the Federal Reserve targets a 2% inflation rate using the PCE deflator, a close relative of the CPI). They also connect to the concept of real vs. nominal values: once you can calculate the inflation rate, you can convert nominal GDP to real GDP, and nominal wages to real wages. The CPI biases are relevant when you study income inequality and poverty measurement, because overstated inflation makes real income growth look slower than it truly is.
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