Chapter 9: Problem 11

How do economists use a basket of goods and services to measure the price level?

Short Answer

Expert verified

Economists use a basket of goods and services to measure the price level by creating a representative basket of commonly consumed items, monitoring the prices of these items over time, calculating the Consumer Price Index (CPI) using the price data, and analyzing changes in CPI to understand overall price level changes in the economy. The CPI formula is given by: \(CPI = \cfrac{\sum_{i=1}^{n} (P_it \times W_i)}{\sum_{i=1}^{n} (P_ib \times W_i)} \times 100\), where \(P_it\) and \(P_ib\) are the prices of item i at time t and the base period, respectively, \(W_i\) is the weight of item i in the basket, and n is the number of items in the basket.

Step by step solution

Understand the concept of a basket of goods and services

A basket of goods and services is a collection of items that are typically consumed by households. It includes products from various categories such as food, clothing, transportation, housing, etc. Economists use these representative items to analyze and monitor the overall price changes in an economy. By tracking the prices of these items over time, they can calculate the average price level and measure inflation.

Create the basket of goods and services

The first step is to create a representative basket of goods and services. To ensure that the basket is representative, it should include items that the majority of the population consumes. This is typically done by conducting surveys and analyzing the spending habits of households. Based on the data gathered, economists will decide on a fixed set of items to include in the basket, as well as their respective weights depending on their importance in the overall consumption pattern.

Monitor prices of items in the basket

Once the basket has been created, economists collect and monitor the prices of the individual items in the basket. They gather data on the prices regularly, usually on a monthly basis, from various sources such as retail outlets, service providers, and online stores. This data will be used to calculate the average price of the items in the basket.

Calculate the Consumer Price Index (CPI)

The Consumer Price Index (CPI) is an essential measure calculated using the price data collected for the items in the basket. To calculate the CPI, economists use a base period and assign it a value of 100. The prices of the individual items in the basket are compared to their prices in the base period, and their respective weights in the basket are taken into account. The result is a single index number that represents the overall price level in the economy compared to the base period. CPI = \(\cfrac{\sum_{i=1}^{n} (P_it \times W_i)}{\sum_{i=1}^{n} (P_ib \times W_i)} \times 100\) Where: - \(P_it\) is the price of item i at time t - \(P_ib\) is the price of item i during the base period - \(W_i\) is the weight of item i in the basket - n is the number of items in the basket

Analyze CPI to measure price level changes

By analyzing the changes in the CPI over time, economists can measure the changes in the overall price level. An increase in the CPI indicates higher prices, which is a sign of inflation, while a decrease in the CPI suggests lower prices, which is a sign of deflation. Policymakers and central banks closely monitor the CPI to implement appropriate monetary and fiscal measures to stabilize the economy and maintain price stability.