The consumer price index and inflation

• Consumer price index (CPI): for any period, a measure of the cost in that period of a standard basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year.

  

• Price index: measure of the average price of a given quality of goods or services relative to the price of the same goods or services in a base year.

• Rate of inflation: annual percentage rate of change in the price level, as measured, for example, by the CPI.

• Deflation: situation in which the prices of most goods and services are falling over time so that inflation is negative.

• Core rate of inflation: rate of increase of all prices except energy and food.

• Nominal quantity: quantity that is measured in terms of its current dollar value.

• Real quantity: quantity that is measured in physical terms - for example, in terms of quantities of goods and services.

• Deflating (a nominal quantity): process of dividing a nominal quantity by a price index (such as the CPI) to express the quantity in real terms.

• Real wage: wage paid to workers measured in terms of purchasing power; the real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period.

• Indexing: practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index.

  • Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation.

The costs of inflation: not what you think

• Price level: measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI.

• Relative price: price of a specific good or service in comparison to the prices of other goods and services.

• Hyperinflation: situation in which the inflation rate is extremely high.

Inflation and interest rates

• Real interest rate: annual percentage increase in the in purchasing power of a financial asset; the real interest rate on any asset equals the nominal interest rate on that asset minus the inflation rate.

  

• Nominal interest rate (or market interest rate): annual percentage increase in the nominal value of a financial asset.

• Inflation-protected bonds: bonds that pay a nominal interest rate each year equal to a fixed real rate plus the actual rate of inflation during that year.

• Fisher effect: tendency for nominal interest rates to be high when inflation is high and low when inflation is low.