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?

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Inflation is a measure of the relative purchasing power of a unit of currency—in this case, a dollar. Inflation is a term typically used to denote an overall trend, as opposed to a change in a specific individual's purchasing power. But let's consider the individual perspective for a moment. Based upon the information given, we cannot conclude that the sellers of fish, meat, or fruit are better off, or worse off, than before, because we lack information about how great the supplies of those commodities are, what proportion of the market they each constitute, and what the consumer responses are to the change in prices. If each of the commodities constitute 1/3 of the market and when the price of fish doubles, everyone eats only meat and fruit instead of fish, then, overall, the consumers are spending less money and experience an increase in their buying power, which would not constitute an overall weakening of their buying power, or "inflation."

But if for some reason fish was a required (and majority) part of the population's diet, then they'd be spending twice as much, overall, for the same amount of fish or the same amount for half as much fish. Individuals are free to alter their behavior in response to price changes, so some individuals could choose to purchase meat instead of fish and that would save them money yet perhaps disadvantage the meat producers. But because we don't know what percentage of the market each food group accounts for, or what percentage of the population consumes how much of each, or what proportion of the population work in each of the individual industries, it is impossible to tell whether or not there is an overall increase or decrease in the purchasing power of the dollar.

In order to construct a simple measure of the "change in the [overall] price level", you would need to construct an equation consisting of the proportion of the market each commodity represents and their respective prices at the beginning of the year to come up with the "average" commodity price. Call this "P1". Then for the end of the year "average" commodity price comparison, you would need to update the figures in your equation for not only the "new" prices, but also for the "new" proportions of the market that each commodity represents to take into account any changes in purchasing behaviors during the year. Call this "P2". If P2 is larger than P1, then it is fair to conclude that inflation has occurred.

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Inflation can be explained as either the rise in prices across the market or the decrease in the value of a dollar.

In the given scenario, where the price of fish went up and the price of meat went down, inflation did not technically occur. However, this may lead to inflation down the road because the person selling the meat will need to earn a larger profit in order to be able to afford the fish. To increase his profit, he would have to raise the price of the meat, and the person selling the fruit would do the same.

One way to measure the overall price level would be to find the average amount spent at the beginning of the year opposed to the end of the year. If consumers buy less fish, but more meat at the end of the year, the price level would be less significant.

For example, in the beginning of the year a family bought two pounds of each good and spent a total of $14. At the end of the year, they bought 1 pound of fish, two pounds of fruit, and three pounds of meat. They still spent $14, but the amount of each product is different.

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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.

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