Consumer Price Index—a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. (Source: investopedia.com). The basket of consumer goods that we are talking about is a sample of goods and services that are typically bought by your average household.
Defining Inflation
So far, we've looked at GDP, which shows production, and unemployment, which describes the labor force. Inflation is another important economic concept that measures the general level of prices in an economy over time. Inflation is usually measured by the percentage change in a price index, such as the Consumer Price Index (CPI) or the GDP deflator.
Inflation occurs when the general level of prices in an economy is rising. It is expressed as a percentage and represents the rate at which the general price level is increasing over time. For example, if the inflation rate is 3%, it means that the general level of prices in the economy is increasing at a rate of 3% per year.
Deflation is the opposite of inflation and occurs when the general level of prices in an economy is falling. Deflation is expressed as a negative percentage and represents the rate at which the general price level is decreasing over time.
Disinflation is a slower rate of inflation, or a slowing down of the rate at which the general price level is increasing. For example, if the inflation rate was previously 5% and it slows down to 3%, it would be considered disinflation.
Inflation, deflation, and disinflation are all important economic concepts that can have significant impacts on an economy. Inflation can affect the purchasing power of money, as prices for goods and services rise faster than wages or incomes. Deflation can also have negative effects, as it can lead to a decline in demand and a decrease in economic activity. Central banks and governments typically aim to keep inflation within a certain range, as too high or too low of an inflation rate can have negative impacts on the economy. For the United States, this is roughly 2%. We'll talk about how the government and economic policy-makers target these variables later in the course - get excited!
Here's a graph of what the inflation rate has been throughout the latter half of the 20th century. Note that in general, recessionary periods bring with it lower inflation. The exception to this is the recession in the 1970s. This is because the economy experienced stagflation, in which prices rose and the economy contracted. This was because of oil crises.
Price Indices and the CPI
A price index is a statistical measure that reflects the changes in the general level of prices for a basket of goods and services over time. Price indices are commonly used to measure inflation and deflation, as they provide a way to track changes in the general price level of an economy.
One common price index is the Consumer Price Index (CPI), which measures the changes in the prices of a basket of goods and services consumed by households. The CPI is calculated by the Bureau of Labor Statistics in the United States and is used to measure the changes in the cost of living over time.
The CPI is based on a market basket of goods and services that is representative of the purchases made by households. The market basket includes a wide range of goods and services, including food, housing, clothing, transportation, and medical care. The prices of these goods and services are collected and used to calculate the CPI.
To calculate the CPI, the Bureau of Labor Statistics collects price data for the goods and services in the market basket from a sample of retailers, service providers, and other sources. These prices are then used to calculate the cost of the market basket at a specific point in time, known as the base period. The CPI is then calculated by comparing the cost of the market basket in the current period to the cost of the market basket in the base period, and expressing the change as a percentage.
The CPI is used to measure the changes in the cost of living over time and is often used to adjust wages, Social Security payments, and other income for inflation. It is also used to make international comparisons of inflation rates and to inform policy decisions related to monetary policy.
One source of bias in the CPI is the substitution bias, which occurs when consumers switch to cheaper alternatives as the prices of certain goods and services rise. If the CPI does not take into account these substitutions, it may overstate the actual increase in the cost of living.
Practice Problems
How to Calculate the CPI
The CPI defines a base year in which all other index values are based on. At the base year, the value is 100, and all other numbers represent a percent increase or decrease from the base year. For example, a CPI of 110 implies that prices have risen 10% since the base year. To find the CPI for a given year, divide that market basket by the base year and multiply by 100 convert to a percent.
To calculate the inflation rate, just calculate the percent change in prices or in CPIs. Percent change is defined as (final - initial) / initial 100.
Formulas
Sample Problem
United States Market Basket - 2016
United States Market Basket - 2017
United States Market Basket - 2018
The first step in calculating either the CPI or the inflation rate is to figure out the value of each market basket. Once you have calculated the market basket, then you can figure out both the CPI for each year and the inflation rate from year to year.
To find the value of the market basket for each year, you simply multiply Price x Quantity for each good and then add all those amounts together. Let's use 2016 as the base year in this example.
Market Basket Value for 2016 = ($3 x 10) + ($2 x 10) + ($5 x 10) = $100
Market Basket Value for 2017 = ($3.25 x 10) + ($3.50 x 10) + ($5.25 x 10) = $120
Market Basket Value for 2018 = ($3.50 x 10) + (3.50 x 10) + (5.50 x 10) = $125
💡When calculating the CPI for the base year, you are always going to get a 100 as the answer. The reason for this is because you divide the value of the market basket for the base year by itself.
2016 CPI = ($100/$100) x 100 = 100
2017 CPI = ($120/$100) x 100 = 120
2018 CPI = ($125/$100) x 100 = 125
2016 to 2017 Inflation Rate = ((120-100)/100) x 100 = 20%
2016 to 2018 Inflation Rate = ((125-100)/100) x 100 = 25%
Frequently Asked Questions
What is the consumer price index and how does it actually work?
The CPI (consumer price index) is a price index that tracks the cost of a fixed “basket” of goods and services over time relative to a base year. To build it you pick a basket, find total cost in the base year and in the current year, then compute CPI = (Cost this year / Cost base year) × 100. The inflation rate = % change in the CPI from one year to the next. You use the CPI to deflate nominal values into real terms (real wage = nominal wage ÷ (CPI/100)). On the AP exam you should be able to calculate CPI, the inflation rate, and changes in real variables (CED MEA-1.F). Remember a key shortcoming: CPI uses a fixed basket so it can overstate inflation (substitution bias). For extra practice and review of examples, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and the practice problem bank (https://library.fiveable.me/practice/ap-macroeconomics).
How do you calculate the CPI step by step for the AP exam?
Step-by-step (what to show on the AP exam): 1. Pick the fixed basket: list quantities of goods/services and their prices in the base year and the current year. 2. Compute cost of basket in base year: sum(quantity × base-year price). Label it Costbase. 3. Compute cost of same basket in current year: sum(quantity × current-year price). Label it Costcurrent. 4. Calculate CPI: (Costcurrent / Costbase) × 100. Use base year CPI = 100. 5. Find inflation rate between years: [(CPIcurrent − CPIprevious) / CPIprevious] × 100%. 6. To get real variables (e.g., real wage): Real = Nominal / (CPI/100). Show each arithmetic step and circle final answers—AP graders want work. Know vocabulary (inflation, deflation, disinflation, substitution bias) and that CPI measures a fixed basket, which can overstate true cost-of-living (substitution bias). For more examples and AP-style practice, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh), unit overview (https://library.fiveable.me/ap-macroeconomics/unit-2) and 1000+ practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between inflation, deflation, and disinflation?
Inflation = a sustained rise in the overall price level—the inflation rate is positive. You measure it as the percent change in a price index (like CPI). Example: CPI 100 → 105 is 5% inflation. (CED: MEA-1.F.1–F.3) Deflation = a sustained fall in the overall price level—the inflation rate is negative. Example: CPI 100 → 98 is −2% (prices fell). Disinflation = a slowdown in the rate of inflation, but prices are still rising. Example: inflation falls from 5% to 3% (CPI still up, just growing more slowly). Why it matters for AP Macro: you should be able to define these terms, calculate inflation from a CPI, and interpret real vs. nominal changes (MEA-1.F). For extra practice and explanations, check the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh), the Unit 2 overview (https://library.fiveable.me/ap-macroeconomics/unit-2), and lots of practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
I'm confused about how to calculate the inflation rate using CPI - can someone explain?
Inflation rate using the CPI = the percent change in the CPI between two periods. Steps: 1) Get CPI this year and CPI last year. 2) Compute change: CPIthis − CPIlast. 3) Divide by CPIlast and multiply by 100. Formula: Inflation rate = [(CPIthis − CPIlast) / CPIlast] × 100%. Example: If CPIlast = 120 and CPIthis = 126, inflation = [(126 − 120)/120] × 100% = 5%. This is exactly what the CED says: the inflation rate is the percentage change in a price index (EK MEA-1.F.3). Remember CPI measures a fixed basket (EK MEA-1.F.2) so it can overstate inflation because of substitution bias (EK MEA-1.G.1). If you want step practice and AP-style problems, check the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and more practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
How do I find real wages from nominal wages and the price level?
Real wages = nominal wages “deflated” by the price level. Use the CPI (or another price index) like this: Real wage = (Nominal wage ÷ Price index) × 100 (If CPI is already indexed to 100 in the base year, that ×100 puts the result in base-year dollars.) Example: Nominal wage = $20/hour, CPI = 125 Real wage = (20 ÷ 125) × 100 = $16/hour (in base-year dollars). Why this matters for the AP: EK MEA-1.F.4 says real variables are nominal variables deflated by the price level, and you’ll be asked to show this work on the exam (free-response and numerical items). For more examples and practice, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
What does it mean that CPI measures a "fixed basket of goods"?
Saying the CPI measures a “fixed basket of goods” means the Bureau of Labor Statistics picks a set of goods and services and fixes the quantities (from a base-period survey). Each month/ year the CPI tracks how much it would cost to buy that same bundle at current prices and compares it to the cost in the base year (base-year index = 100). That’s why CPI tells you how much income a consumer would need to maintain the same standard of living over time (CED EK MEA-1.F.1–1.F.2). A key shortcoming: because quantities are fixed, CPI can’t account for consumers substituting toward relatively cheaper goods, so it tends to overstate true inflation (substitution bias, EK MEA-1.G.1). For more AP-aligned review and practice on this topic, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
Why does the CPI overstate inflation and what is substitution bias?
The CPI overstates inflation mainly because it uses a fixed basket of goods and services (EK MEA-1.F.2). When relative prices change, consumers don’t keep buying the exact same items— they substitute toward cheaper alternatives. Because the CPI’s basket is fixed, it can’t fully capture that behavior, so it records a larger rise in cost-of-living than consumers actually experience. Substitution bias is this specific problem: when the price of one good rises, people buy less of it and more of a relatively cheaper good, but the fixed-basket CPI still weights the expensive good as if consumption didn’t change. Example: if beef gets a lot more expensive and you switch to chicken, CPI still reflects the old beef-heavy basket and overstates how much more you need to maintain your standard of living. The CED notes substitution bias as a key CPI shortcoming (EK MEA-1.G.1). For a deeper review, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and try related practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do you calculate percentage change in price index for inflation rate?
Take the percent change in the price index between two periods: (New index − Old index) ÷ Old index × 100. That gives the inflation rate. Use whichever price index you’re given (CPI or the GDP deflator)—both are valid on the AP (CED EK MEA-1.F.2 & EK MEA-1.F.3). Example: CPI last year = 120, CPI this year = 126. Inflation rate = (126 − 120) / 120 × 100 = 6 / 120 × 100 = 5%. On the exam, show the formula and your arithmetic clearly (AP free-response often requires showing work). If you want more practice or review, check the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh), the Unit 2 overview (https://library.fiveable.me/ap-macroeconomics/unit-2), and lots of practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between CPI and GDP deflator?
CPI and the GDP deflator both measure price-level changes, but they do it differently. CPI tracks the cost of a fixed “basket” of goods and services bought by a typical urban consumer (so it’s a cost-of-living index); because the basket is fixed, CPI suffers substitution bias and can overstate inflation (CED EK MEA-1.F.2 and EK MEA-1.G.1). The GDP deflator measures prices of all final goods and services produced domestically in a year (so it uses current-year quantities), which means it includes investment and government purchases and excludes imports. Practically: use CPI to track consumer living costs and the GDP deflator to deflate nominal GDP into real GDP. On the AP exam you might be asked to calculate inflation from either index (EK MEA-1.F.3) or to explain shortcomings of CPI. For a focused review, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand how to convert nominal variables to real variables - help?
To convert a nominal variable (like nominal wage, nominal GDP, or price) into a real variable, deflate it by the price index. Use this formula: Real value = Nominal value ÷ (Price index / 100) Or equivalently: Real = Nominal × (100 / CPI) Example: If nominal wage = $50,000 and CPI = 125, then real wage = 50,000 ÷ (125/100) = 50,000 × 0.8 = $40,000 (in base-year dollars). That removes the effect of inflation so you can compare purchasing power over time. AP tip: the CED expects you to calculate CPI, the inflation rate (percentage change in the index), and convert nominal → real (EK MEA-1.F.3–4). Practice these steps and worded explanations for free-response and multiple-choice (see the Topic 2.4 study guide for worked examples: https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh). For more practice problems, try the AP Macroeconomics question bank (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know which year is the base year when calculating CPI?
The base year is the year the CPI is defined as 100—but you don’t guess it. In problems the base year will be given (or you’ll see a year with CPI = 100). Practically: find the year labeled as the base year in the question or the table; if a CPI column shows one year’s index = 100, that’s the base. Then CPI for any year = (cost of fixed basket in that year / cost of basket in base year) × 100. Use that CPI to get inflation rates (percentage change in CPI) and to deflate nominal values into real ones (nominal ÷ (CPI/100)). This follows the CED idea that CPI measures a fixed basket relative to the base year (EK MEA-1.F.2) and that inflation = % change in a price index (EK MEA-1.F.3). For more practice and examples, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and Unit 2 resources (https://library.fiveable.me/ap-macroeconomics/unit-2).
What happens to real income when inflation goes up but nominal income stays the same?
Real income falls. By AP definition, a real variable (real income or real wage) = nominal income deflated by the price level (often the CPI). If nominal income stays the same while the CPI rises, your purchasing power declines roughly by the inflation rate. Quick formula: Real income = (Nominal income / CPI) × 100. So if nominal income = $50,000 and the CPI rises 5%, real income falls by about 5% (you can buy ~5% less than before). On the exam you should show the calculation or state that real variables are nominal variables divided by a price index (CED EK MEA-1.F.4). For extra practice on CPI, inflation rate, and calculating changes in real variables, check the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and try practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
Can someone explain why CPI has shortcomings as a measure of inflation?
CPI has useful info but some important shortcomings you should know for the exam (CED: MEA-1.G / EK MEA-1.G.1–.3). Key issues: - Substitution bias: CPI uses a fixed basket, so when consumers switch to cheaper alternatives the CPI doesn’t fully reflect that substitution—this makes CPI tend to overstate true cost-of-living inflation. - New goods and quality changes: New products and improvements (better phones, safer cars) raise consumer value, but a fixed basket or slow updates can miss quality-adjusted price changes. - Outlet and coverage bias: CPI may not capture discounts, online sales, or spending patterns of all households, so it can misstate what typical consumers actually pay. Because CPI measures a fixed-basket price change rather than a perfect cost-of-living index, it’s an imperfect inflation measure—know this for MEA-1.F/G. For a quick review, check the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh). For extra practice, try problems at (https://library.fiveable.me/practice/ap-macroeconomics).
How do I calculate how much purchasing power someone lost due to inflation?
Take the nominal amount you’re holding (or earning) and deflate it with the price index to get its real purchasing power. Formula and quick steps: - Real value in year t (in base-year dollars) = Nominal amount ÷ (CPI_t / 100). - If you keep the same nominal amount from year 1 to year 2, percent change in purchasing power = (CPI1 / CPI2 − 1) × 100. - If CPI rises, this is negative—the percent you lost. Example: CPI1 = 100, CPI2 = 125, same $1,000 nominal income: percent change = (100/125 − 1)×100 = (0.8 − 1)×100 = −20%. You lost 20% of purchasing power. This uses the AP idea that real variables = nominal ÷ price level (CED EK MEA-1.F.4). For more practice and examples, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and lots of practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What's the formula for finding real variables from nominal variables?
Use the price index to “deflate” nominal values. Formula: Real value = (Nominal value ÷ Price index) × 100 If the price index is a CPI (or GDP deflator) expressed with base-year = 100, plug that index in. Equivalently: Real = Nominal × (Base-year price level / Current price level). Example: nominal wage = $50,000, CPI = 125 → real wage = ($50,000 ÷ 125) × 100 = $40,000 (in base-year dollars). Why this matters for the AP: the CED expects you to calculate real variables and show that nominal values are “deflated by the price level” (EK MEA-1.F.4). For review and extra practice on CPI, inflation, and converting nominal ↔ real, see the Topic 2.4 study guide (https://library.fiveable.me/ap-macroeconomics/unit-2/price-indices-inflation/study-guide/K57UNh4rO3CE0MWoONLh) and the AP Macro practice problems (https://library.fiveable.me/practice/ap-macroeconomics).