Chapter 5, Problem 1P

To determine

To define inflation and the overall change in price level.

Explanation of Solution

Inflation is defined as a situation in which the general price level of the economy rises continuously. In the given situation there are only three goods in the economy and hence the overall price level can be calculated as the average of the prices of the three items, using the following equation.

$\begin{array}{c}{\text{Average price}}_{\text{January 1,2015}}=\frac{{\text{Price}}_{\text{cashews}}+{\text{Price}}_{\text{pecans}}+\text{Price}{\text{almonds}}_{}}{3}\\ =\frac{12.50+4+5.50}{3}\\ =\frac{22}{3}\\ =7.33\end{array}$

The average price in the beginning was $7.33.

It is given that the price of goods changes by the end of the year. The new average index can be calculated as follows,

$\begin{array}{c}{\text{Average price}}_{\text{end}}=\frac{{\text{Price}}_{\text{cashews}}+{\text{Price}}_{\text{pecans}}+\text{Price}{\text{almonds}}_{}}{3}\\ =\frac{17+4+3}{3}\\ =\frac{24}{3}\\ =8\end{array}$

The average price level by the end of the year is $8. From the calculations it is obvious that the average price level has increased by the end of the year. This is simple method of calculating the overall price level. A better measure of change in price level can be computed if one knows the relative importance or weights of each of these commodities in the consumption basket of individuals.

Economics Concept Introduction

Concept Introduction:

Inflation: Inflation is defined as a phenomenon in which the overall price level of the economy continues to increase for a period of time. Inflation reduces the purchasing power of money.