Define inflation. Assume that you live in a simple economy in which only three goods are produced and traded: fish, fruit, and meat. Suppose that on January 1, 2010, fish sold for $2.50 per pound, meat was $3.00 per pound, and fruit was $1.50 per pound. At the end of the year, you discover that the catch was low and that fish prices had increased to $5.00 per pound, but fruit prices stayed at $1.50 and meat prices had actually fallen to $2.00. Can you say what happened to the overall “price level”? How might you construct a measure of the “change in the price level”? What additional information might you need to construct your measure?
Inflation is defined as the rise in average price levels. This is to be distinguished from the rise in the cost of one particular good or service. In order for inflation to occur, the average level of prices throughout the economy must rise, but not every single good or service must experience a price increase.
In your hypothetical economy with only three products, it is hard to say if inflation has occurred. We could try to determine the overall price level by adding together the prices of the three goods. At the beginning of 2010, the price level would have been $7 by this measure. By the end of the year, the level would have been $8.50. If we are going to use this as our measure, inflation has occurred.
The simplest way to look at change in price levels is to calculate the percent change that has occurred. You take the second level (end of the year) subtract the first, and divide the difference by the first level. In this case, you would end up with $1.50/$7 = 21.4%, which is a tremendous amount of inflation for one year.
The one piece of information that would be helpful is how much of each good people buy. Let’s say that fish only accounts for 5% of what people buy. In that case, the rise in its price would not really have that much of an effect. That means that we might want to know how much of each good people buy so that we can weight their prices when calculating inflation.