Question

The CPI is 180 in year 1 and 174 in year \(2 .\) What is the deflation rate between the two years?

Short answer

The deflation rate between the two years is approximately 3.33%.

Step-by-step solution

Identify given values

In this situation, the CPI in year 1 is specified as 180, while in year 2, the CPI is given as 174.

Apply the deflation rate formula

With the CPI values for each year, the deflation rate formula can now be used. This formula is deflation rate = (CPI year 1 - CPI year 2) / CPI year 1 * 100%.

Substitute values into the formula

Substitute the given values into the formula: deflation rate = (180 - 174) / 180 * 100%.

Perform the calculation

Perform the subtraction inside the parentheses, divide by 180, then multiply by 100% to get the deflation rate.

Key concepts

Consumer Price Index (CPI)

The Consumer Price Index, or CPI, is a critical economic indicator that measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It is vital for understanding economic health and is used for several purposes including cost-of-living adjustments in contracts and to review economic policies.

To comprehend how CPI figures are used in calculating deflation, consider an example: if a CPI is 180 in one year and then drops to 174 the following year, it suggests that the average price of the goods and services in the market basket has decreased. This price decrease means consumers are paying less on average for that basket, which can lead to deflation—a reduction in the general price level of goods and services in an economy. Thus, the CPI serves as a barometer for price level changes, allowing economists and policymakers to track and respond to both inflationary and deflationary pressures.

Economic Indicators

Economic indicators are statistics that provide insights into the economic performance of a country. They are used to understand the health of the economy, formulate monetary and fiscal policies, and make investment decisions. The Consumer Price Index is one of these indicators, specifically capturing changes in consumer prices, but there are others that focus on different areas such as employment levels, gross domestic product (GDP), industrial production, and business inventories.

An indicator like the CPI can signal an economy's inflationary or deflationary trend. Deflation, a decrease in the overall price level, is indicated when the CPI decreases between two time points. Conversely, an increase in CPI represents inflation. Policymakers meticulously monitor these indicators to adjust economic strategies, aiming to stabilize the economy and achieve growth objectives. In our exercise, calculating the deflation rate between the two years using the CPI values is a practical application of these economic indicators in real-life scenarios.

Price Level Changes

Price level changes refer to the average movement in prices of goods and services over time within an economy. These changes can be tracked using various economic indicators, with the CPI being one of the most prominent for consumer prices. Prices can shift due to various factors like changes in supply and demand, currency valuation, and fiscal and monetary policy.

In the context of deflation, a situation depicted by a descending CPI, prices are falling, which might sound beneficial for consumers in the short term because they can buy more with the same amount of money. However, prolonged deflation can lead to lower production, wage cuts, and increased unemployment rates, eventually dampening economic growth. To calculate the rate of deflation, which represents the percentage reduction in the CPI, the provided exercise demonstrates the necessary steps. By understanding how to analyze price level changes through CPI data, students and professionals can gain insight into economic trends and their potential consequences for the economy at large.