HKDSE Economics Study Notes: Measuring the General Price Level
Hey everyone! Have you ever heard your parents or grandparents say something like, "Back in my day, a bowl of wonton noodles only cost $10!"? Why do things seem to get more expensive over time? This chapter is all about how we measure these changes in prices across the whole economy. It's super important because it affects the value of your savings and how much your money can actually buy.
In these notes, we'll break down how economists measure the general price level using two key tools: the Consumer Price Index (CPI) and the GDP deflator. Don't worry, we'll take it one step at a time with simple examples!
1. What is the General Price Level?
First things first, let's get our key terms straight.
The general price level is a measure of the overall or average prices of goods and services in an economy. It's not just the price of one item, like a cup of bubble tea, but a weighted average of thousands of items.
When this average price level changes, we have special names for it:
- Inflation: This is a sustained increase in the general price level. When there is inflation, the purchasing power of money falls – each dollar buys you less than it did before. (e.g., The general price level rises by 3% over a year).
- Deflation: This is a sustained decrease in the general price level. This is less common, but it means the purchasing power of money is rising. (e.g., The general price level falls by 1% over a year).
The key word here is "sustained". A one-time price jump for a few items isn't inflation. It has to be a broad and ongoing trend.
Key Takeaway
The general price level is the average price of everything. When it goes up continuously, it's inflation. When it goes down continuously, it's deflation.
2. Tool #1: The Consumer Price Index (CPI)
The CPI is the most common way you'll see inflation reported in the news. It's designed to measure the price changes that affect households like yours.
What is the CPI?
Think of the CPI as a "fixed shopping basket". The government creates a list of goods and services that a typical household buys regularly. This basket includes things like:
- Food and drinks (e.g., rice, vegetables, fast food)
- Housing (e.g., rent for private housing)
- Transport (e.g., MTR and bus fares)
- Miscellaneous goods and services (e.g., movie tickets, haircuts, mobile phone plans)
The government then tracks the total cost of this exact same basket of goods and services over time. To make comparison easy, they use a base year, which is a starting point where the CPI is set to 100.
For example, if the base year is 2020 (CPI=100) and the CPI in 2023 is 106, it means the cost of living for a typical household has increased by 6% since 2020.
Calculating the Inflation Rate with CPI
This is a calculation you need to know! The formula measures the percentage change in the CPI from one year to the next.
$$ \text{Inflation Rate} = \frac{\text{CPI}_{\text{current year}} - \text{CPI}_{\text{previous year}}}{\text{CPI}_{\text{previous year}}} \times 100\% $$Step-by-step Example:
Suppose the CPI in Hong Kong was 104 in 2022 and it rose to 106.08 in 2023. What was the inflation rate in 2023?
- Identify the numbers:
Current Year CPI = 106.08
Previous Year CPI = 104 - Plug them into the formula:
$$ \text{Inflation Rate} = \frac{106.08 - 104}{104} \times 100\% $$ - Calculate the result:
$$ \text{Inflation Rate} = \frac{2.08}{104} \times 100\% = 0.02 \times 100\% = 2\% $$
So, the inflation rate in 2023 was 2%.
Quick Review: CPI
What is it? Tracks the cost of a fixed basket of goods and services bought by a typical consumer.
Strength: It directly measures the change in the cost of living for households.
3. Tool #2: The Implicit Price Deflator of GDP (GDP Deflator)
The GDP deflator is another important price index, but it's much broader than the CPI. To understand it, we need a quick reminder of Nominal and Real GDP.
- Nominal GDP: The total value of all goods and services produced in an economy, measured using current year prices.
- Real GDP: The total value of all goods and services produced, measured using constant base-year prices. Real GDP is adjusted for inflation.
What is the GDP Deflator?
The GDP deflator measures the change in prices of all goods and services produced domestically. It "deflates" the Nominal GDP (which is inflated by price rises) to find the Real GDP.
The formula to find the deflator itself is:
$$ \text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 $$Like the CPI, the GDP deflator in the base year is always 100 because Nominal GDP equals Real GDP in that year.
Calculating the Inflation Rate with the GDP Deflator
The formula is exactly the same as for the CPI, just using the GDP deflator values instead.
$$ \text{Inflation Rate} = \frac{\text{GDP Deflator}_{\text{current year}} - \text{GDP Deflator}_{\text{previous year}}}{\text{GDP Deflator}_{\text{previous year}}} \times 100\% $$Step-by-step Example:
An economy's GDP deflator was 120 in 2022 and 125 in 2023. What was the inflation rate?
- Identify the numbers:
Current Year Deflator = 125
Previous Year Deflator = 120 - Plug them into the formula:
$$ \text{Inflation Rate} = \frac{125 - 120}{120} \times 100\% $$ - Calculate the result:
$$ \text{Inflation Rate} = \frac{5}{120} \times 100\% \approx 4.17\% $$
So, the inflation rate measured by the GDP deflator was approximately 4.17%.
Key Takeaway
The GDP Deflator measures the average price change of all domestically produced goods and services. It is calculated using Nominal and Real GDP.
4. CPI vs. GDP Deflator: The Big Comparison
The syllabus requires you to compare these two tools in terms of their coverage and weighting. This is a very common exam topic!
Don't worry, it's easier than it sounds. Let's break it down.
Coverage (What is included in the measurement?)
- CPI: Measures a basket of goods and services purchased by consumers.
- This means it INCLUDES imported goods that consumers buy, like a new iPhone from the US or salmon from Norway.
- It EXCLUDES goods not bought by consumers, like a new machine for a factory or a government-built bridge.
- GDP Deflator: Measures all goods and services produced domestically (within the country).
- This means it EXCLUDES all imported goods. The iPhone and salmon are not in the GDP deflator.
- It INCLUDES items consumers don't buy directly, like factory machines, new buses, and government expenditure on infrastructure, as long as they are produced in the country.
Weighting (How is the importance of each item decided?)
- CPI: Uses fixed weights based on a fixed "shopping basket". The importance of each item (e.g., rice vs. movie tickets) is determined by how much a typical household spent on it in the base period. This basket composition does not change from year to year.
- GDP Deflator: Uses changing weights. The importance of each good or service depends on how much of it the economy is producing in the current year. If the economy produces more computers this year than last year, computers will automatically have a bigger weight in this year's GDP deflator.
Did you know?
The Hong Kong government updates the "fixed basket" for the CPI every few years to reflect changes in what people buy. For example, spending on streaming services like Netflix might be in the new basket, while VCD rentals are definitely out!
Summary Table: CPI vs. GDP Deflator
Here's a simple table to help you remember the key differences. This is perfect for revision!
| Feature | Consumer Price Index (CPI) | GDP Deflator |
| Coverage | A basket of goods & services bought by consumers. Includes imports. |
All goods & services produced domestically. Excludes imports. |
| Weighting | Uses fixed weights from a fixed base-year basket. | Uses changing weights based on current year's production. |
Common Mistake to Avoid!
A common error is mixing up which index includes imports. Remember: CPI is for Consumers, and consumers buy imported goods. GDP is about what's produced Geographically inside the country, so no imports!
Chapter Summary
You made it! Here are the absolute key points to take away:
- The general price level is the economy's average price level. A sustained increase is called inflation.
- The Consumer Price Index (CPI) measures the price of a fixed basket of goods and services bought by consumers, and it includes imports.
- The GDP Deflator measures the price of all domestically produced goods and services, using changing weights based on current production. It excludes imports.
- You must know how to calculate the inflation rate using both indices with the percentage change formula.
Understanding these concepts is a huge step in your macroeconomics journey. Keep reviewing the comparison table, and you'll master this topic in no time!