Short on time? This page is the recap. For explanations and worked examples, use the full study guide.
Recap
- The CPI compares the cost of a fixed market basket of consumer goods and services in a given year with its cost in the base year.
- It shows how much more income a household needs to keep the same standard of living.
- Inflation: the price level rises. Deflation: it falls. Disinflation: inflation is still positive but lower than before.
- Real variables are nominal variables adjusted (deflated) by a price index.
- The CPI tends to overstate inflation: substitution bias, quality changes, new goods.
Key relationships
| Relationship | Formula | Use it to |
|---|---|---|
| CPI | (cost of basket in year t ÷ cost in base year) × 100 | build the index |
| Inflation rate | (new index − old index) ÷ old index × 100 | find the percentage change in prices |
| Real value | nominal value ÷ index × 100 | express money in base-year purchasing power |
| Value in another year’s money | value × (index in target year ÷ index in original year) | compare money across years |
| Real % change (approx.) | nominal % change − inflation rate | quick check on real changes |
Assumptions behind the numbers
- The basket represents what a typical consumer buys; any one household may differ.
- Quantities in the basket stay fixed between years.
- The same goods are priced each year, with unchanged quality.
- Out of scope: the producer price index (PPI). Calculating the GDP deflator is in Topic 2.6.
Mistakes to avoid
- Index points ≠ percentages unless the earlier index is 100.
- Wrong denominator: divide by the earlier index.
- Inverting the ratio: given-year cost goes on top.
- Calling disinflation “deflation”.
- Changing basket quantities between years.
- Saying substitution makes the CPI understate inflation. It overstates it.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- A basket costs VD 80 in the base year and VD 92 now. What is the CPI? (115)
- The CPI rises from 150 to 156. What is the inflation rate? (4%)
- A nominal wage of VD 840 when the CPI is 120 is worth how much in base-year valdas? (VD 700)
Next: practice questions.