Economics Micro & Macro (CliffsAP)

Price index =

Price of market basket in base year

Price of market basket in specific year (100)

Price index, year 1 = 100

Price index, year 2 =
$

$

10

(^20) #100 200=
Price index, year 3 =
$

$

10

(^25) #100 250=
With our example you can see that for year 1, the price index has to be 100, since that is our base year. The index num-
bers tell us that the price rose from year 1 to year 2 by 100 percent and from year 1 to year 3 by 150 percent.
Another way to measure inflation is to use the GDP deflator. This formula measures the changes in prices of all goods
and services produced in an economy:
Real GDP=Nominal GDPPrice Index

Types of Inflation

In this section, we’ll take a look at the two types of inflation.

Demand-Pull Inflation

Typically, changes in the price level are caused by changes in total spending. As total spending increases, so does con-
sumers’ demand for products. When the economy reaches its capacity yet demand for products is still increasing, pro-
ducers have no choice but to start raising their prices. A collective rise in the price level is a cause of inflation. This type
of inflation, called demand-pull inflation, is illustrated in Figure 3-4.

Figure 3-4

In Figure 3-4, we see that demand has increased from D1, to D2, to D3 as a result of an increase in total spending. In
range 1, output is low in comparison to the economy’s full employment abilities. This low output implies a low level of
total spending, which causes high unemployment and stagnant production of resources. In range 2, demand continues
to expand as a result of further increases in spending. Demand meets full employment output, which tells us that the

Price

Level

Total Spending

Real GDP

Range 1

Range 2

Range 3

D^1

D^2

D^3

National Income Accounting