Key Terms

Key Terms

adjustable-rate mortgage (ARM) a loan a borrower uses to purchase a home in which the interest rate varies with market interest rates base year arbitrary year whose value as an index number economists define as 100; inflation from the base year to other years can easily be seen by comparing the index number in the other year to the index number in the base year—for example, 100; so, if the index number for a year is 105, then there has been exactly 5% inflation between that year and the base year basket of goods and services a hypothetical group of different items, with specified quantities of each one meant to represent a “typical” set of consumer purchases, used as a basis for calculating how the price level changes over time Consumer Price Index (CPI) a measure of inflation that U.S. government statisticians calculate based on the price level from a fixed basket of goods and services that represents the average consumer's purchases core inflation index a measure of inflation typically calculated by taking the CPI and excluding volatile economic variables such as food and energy prices to better measure the underlying and persistent trend in long-term prices cost-of-living adjustments (COLAs) a contractual provision that wage increases will keep up with inflation deflation negative inflation; most prices in the economy are falling Employment Cost Index a measure of inflation based on wages paid in the labor market GDP deflator a measure of inflation based on the prices of all the GDP components hyperinflation an outburst of high inflation that often occurs (although not exclusively) when economies shift from a controlled economy to a market-oriented economy index number a unit-free number derived from the price level over a number of years, which makes computing inflation rates easier, since the index number has values around 100 indexed a price, wage, or interest rate is adjusted automatically for inflation inflation a general and ongoing rise in price levels in an economy International Price Index a measure of inflation based on the prices of merchandise that is exported or imported Producer Price Index (PPI) a measure of inflation based on prices paid for supplies and inputs by producers of goods and services quality/new goods bias inflation calculated using a fixed basket of goods over time tends to overstate the true rise in cost of living, because it does not account for improvements in the quality of existing goods or the invention of new goods substitution bias an inflation rate calculated using a fixed basket of goods over time tends to overstate the true rise in the cost of living, because it does not take into account that the person can substitute away from goods whose prices rise considerably

Key Concepts and Summary

9.1 Tracking Inflation

Economists measure the price level by using a basket of goods and services and calculating how the total cost of buying that basket of goods will increase over time. Economists often express the price level in terms of index numbers, which transform the cost of buying the basket of goods and services into a series of numbers in the same proportion to each other, but with an arbitrary base year of 100. We measure the inflation rate as the percentage change between price levels or index numbers over time.

9.2 How to Measure Changes in the Cost of Living

Measuring price levels with a fixed basket of goods will always have two problems: the substitution bias, by which a fixed basket of goods does not allow for buying more of what becomes relatively less expensive and less of what becomes relatively more expensive; and the quality/new goods bias, by which a fixed basket cannot account for improvements in quality and the advent of new goods. These problems can be reduced in