Question

(Related to the Don't Let This Happen to You on page 681 ) An article in the Wall Street Journal asked "How can inflation be low when everything is so expensive?" The article also noted that "the CPI shows that prices are the highest they've ever been." Is there a contradiction between a low inflation rate as measured by the CPI and the observations that prices are "the highest they've ever been" and everything is "so expensive"? Briefly explain.

Short answer

No, there isn't a contradiction between a low inflation rate, high prices as per the CPI, and the observation that everything is 'so expensive'. This is because inflation refers to the rate at which prices are rising, not the absolute level of prices. Prices can be at an all-time high (as suggested by a high CPI) but if the rate of increase is slowing, the inflation rate could still be low.

Step-by-step solution

Understand Concepts

Firstly, understand the key terms. Inflation is a measure of the rate at which the average price level of a basket of selected goods and services in an economy is rising. On the other hand, Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services.

Analyze the Statement

The statement 'the CPI shows that prices are the highest they've ever been' just indicates that prices of goods and services are higher now than they have been in the past. This doesn't necessarily mean that the inflation rate is high. Inflation rate is the percentage increase in prices from one period to the next.

Reconcile the Observations

While it is true that prices may currently be 'the highest they've ever been', the rate at which these prices are increasing (inflation) could still be low. This is possible if, for example, prices increased sharply in the past but are now increasing at a slower rate. Therefore, there isn't a direct contradiction between the three observations: low inflation rate, high CPI (high prices), and the perception that everything is 'so expensive'.

Key concepts

Inflation Rate

Inflation rate is a metric that reflects how rapidly the general level of prices for goods and services is rising within an economy over a specified period. It's an expression of the increase in the cost of living, showing the percentage change in price levels from one year to the next. If the inflation rate is high, it means that the purchasing power of currency is falling, indicating that consumers need to spend more money to purchase the same quantity of goods or services. In simple terms, if the inflation rate is 3%, it implies that consumers need to pay 3% more this year than they did last year for a particular basket of goods and services.
As an economic indicator, the inflation rate is crucial because it affects decisions made by government agencies, investors, and consumers. For instance, central banks may adjust interest rates in response to inflation to manage economic stability. On a personal level, individuals may seek wage increases to keep up with rising living costs when inflation is high.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) is a measure detailing the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. This basket represents a wide range of items, including food, clothing, shelter, fuels, transportation fares, doctor and dentist services, drugs, and other goods and services that people buy for day-to-day living.

How Is CPI Calculated?

To calculate the CPI, prices are collected for a representative sample of goods and services, and a weighted average is used. This means items that consumers spend more money on, such as housing, will have a greater influence on the overall CPI. The CPI is often used as an indicator to adjust income payments — like Social Security — and as a gauge for monetary policy. It can also act as an economic indicator for inflation, though it is just one tool among many that measure price changes.

Price Level

Price level refers to the average of the current prices of goods and services in an economy at a given time. It's a snapshot of how much an economy's goods and services cost, acting as a reference for measuring inflation. Unlike the inflation rate, which measures the rate of price changes, price level represents the actual prices.
In an exercise, when one observes that the price level is 'the highest it has ever been', it may be true in nominal terms. However, a higher price level does not automatically equate to a higher inflation rate. The latter focuses on the change or movement in prices, rather than the absolute price. Price levels can be informative about the current affordability of products, but they must be contextualized. For example, historical comparisons should account for overall economic growth and changes in currency value.

Economic Indicators

Economic indicators are statistics about economic activities that allow analysts and policymakers to assess the performance of an economy. Widely tracked indicators include GDP growth rate, unemployment rate, retail sales, and housing starts. These indicators are divided into three categories: leading, lagging, and coincident.
Leading indicators, like stock market returns or business inventories, tend to change before the economy starts to follow a particular pattern, and thus, are useful for making predictions. Lagging indicators, including the average duration of unemployment, change after the economy has already begun to follow a trend. Coincident indicators move simultaneously with the economy; an example is personal income. Inflation rate and CPI are two highly observed indicators that fall within the realm of lagging or coincident indicators, as they reflect changes often after they occur or at the time they occur, providing a current state of the economy in terms of price levels and purchasing power.