AP_Krugman_Textbook

would become 2 new dollars an hour, and so on. This would bring the overall U.S.
price level back to about what it was when John F. Kennedy was president.
So would everyone be richer as a result because prices would be only one-seventh as
high? Of course not. Prices would be lower, but so would wages and incomes in general.
If you cut a worker’s wage to one-seventh of its previous value, but also cut all prices to
one-seventh of their previous level, the worker’s real wage—the wage rate divided by the
price level—doesn’t change. In fact, bringing the overall price level back to what it was
during the Kennedy administration would have no effect on overall purchasing power,
because doing so would reduce income exactly as much as it reduced prices. Conversely,
the rise in prices that has actually taken place since the early 1960s hasn’t made America
poorer, because it has also raised incomes by the same amount: real income—income
divided by the price level—hasn’t been affected by the rise in overall prices.
The moral of this story is that the level of prices doesn’t matter: the United States
would be no richer than it is now if the overall level of prices was still as low as it was in
1961; conversely, the rise in prices over the past 45 years hasn’t made us poorer.

... But the Rate of Change of Prices Does

The conclusion that the level of prices doesn’t matter might seem to imply that the in-
flation rate doesn’t matter either. But that’s not true.
To see why, it’s crucial to distinguish between the level of pricesand the inflation rate.
In the next module, we will discuss precisely how the level of prices in the economy is
measured using price indexes such as the consumer price index. For now, let’s look at
the inflation rate,the percent increase in the overall level of prices per year. The infla-
tion rate is calculated as follows:

Inflation rate =× 100

Figure 14.1 highlights the difference between the price level and the inflation rate in
the United States since 1969, with the price level measured along the left vertical axis
and the inflation rate measured along the right vertical axis. In the 2000s, the overall

Price level in year 2 −Price level in year 1

Price level in year 1

module 14 Inflation: An Overview 135

Section 3 Measurement of Economic Performance

figure 14.1

The Price Level versus the

Inflation Rate, 1969–2009

Over the past 40 years, the price level has

continuously gone up. But the inflation rate—

the rate at which consumer prices are

rising—has had both ups and downs.

Source: Bureau of Labor Statistics.

Price

level

Inflation

rate

Year

100

150

250

200

2

0

–2

–4

4

6

8

10

12

16%

14

(^196919701980199020002009)
50
Price level
Inflation rate
The real wageis the wage rate divided
by the price level.
Real incomeis income divided by the
price level.
The inflation rate is the percent change
per year in a price index—typically the
consumer price index.