Practice
Price indices and inflation
A consumer price index from a fixed basket, the inflation rate between two years, and a real wage.
The skill
A price index tracks the cost of one fixed basket of goods. Price the same basket in the base year and in the later year, divide the later cost by the base-year cost, and multiply by 100, so the base year is always 100. The inflation rate is the percentage change in the index from one year to the next. A real wage is the nominal wage divided by the index over 100. Letting the quantities in the basket change between years is the error that breaks the calculation.
A worked example
A price index uses a fixed basket of three goods. 2020 is the base year.
| Good | Quantity in basket | Price in 2020 ($) | Price in 2025 ($) |
|---|---|---|---|
| Movie tickets | 2 | 13 | 16.25 |
| Bus rides | 20 | 3.5 | 4 |
| Gallons of milk | 6 | 4 | 4.75 |
What is the value of the price index in 2025? Round to one decimal place.
Solution
- Cost of the basket in 2020: 2 × 13 + 20 × 3.5 + 6 × 4 = $120.
- Cost of the same basket in 2025: 2 × 16.25 + 20 × 4 + 6 × 4.75 = $141.
- Index = (2025 cost ÷ base-year cost) × 100 = 141 ÷ 120 × 100 = 117.5. The base year is 100 by definition.
Answer: 117.5