Things cost more today than they used to. In the 1920's, a loaf of bread cost
about a nickel. Today it costs more than $1.50. In general, over the past 300
years in the United States the overall level of prices has risen from year to
year. This phenomenon of rising prices is called inflation.

While small changes in the price level from year to year may not be that
noticeable, over time, these small changes add up, leading to big effects. Over
the past 70 years, the average rate of inflation in the United States from year
to year has been a bit under 5 percent. This small year-to-year inflation level
has led to a 30-fold increase in the overall price during that same period.

Inflation plays an important role in the macroeconomic economy by changing
the value of a dollar across time. This section on inflation will deal with
three important aspects of inflation. First, it will cover how to calculate
inflation. Second, it will cover the effects of inflation calculations using
the CPI and GDP measures. Third, it will introduce the effects of
inflation.

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Calculating inflation

Inflation is the change in the price level from one year to the next. The
change in inflation can be calculated by using whatever price index is most
applicable to the given situation. The two most common price indices used in
calculating inflation are CPI and the GDP deflator. Know, though, that
the inflation rates derived from different price indices will themselves be
different.

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Calculating Inflation Using CPI

The price level most commonly used in the United States is the CPI, or
consumer price index. Thus, the simplest and most common method of calculating
inflation is to calculate the percentage change in the CPI from one year to the
next. The CPI is calculated using a fixed basket of goods and services; the
percentage change in the CPI therefore tells how much more or less expensive the
fixed basket of goods and services in the CPI is from one year to the next. The
percentage change in the CPI is also known as the percentage change in the price
level or as the inflation rate.

Fortunately, once the CPI has been calculated, the percentage change in the
price level is very easy to find. Let us look at the following example
of "Country B."