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Measuring inflation with a price index

How a basket of shopping turns into one inflation number.

FinanceMankiw ch. 11About 4 min: 2 reading, 2 practiceUpdated 27 October 2026

General education, not financial advice.

After this lesson you can

Build a simple price index from a basket
Work out inflation from two index values
Explain why the basket is held fixed between updates

Money over time: lesson 3 of 5

Mankiw ch. 14
Compound interest 5 min
Present value 5 min
Mankiw ch. 11
Measuring inflation with a price index 4 min
Real and nominal interest rates 3 min
Bogle ch. 4
Costs and the market return 3 min

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Pairs with Mankiw, Principles of Macroeconomics (6th ed.), chapter 11, "Measuring the Cost of Living": the consumer price index

What it is

Inflation is a rise in the general level of prices. To measure it, statistics offices build a consumer price index (CPI): the cost of a fixed basket of goods and services that a typical household buys, compared over time.

The method has five steps:

Fix the basket: survey households to find what they buy, and how much of each.
Find the prices of everything in the basket, at each date.
Work out the basket's cost at each date. The quantities stay the same; only prices change.
Pick a base year and turn costs into an index: cost this year ÷ cost in the base year × 100. The base year is always 100.
Work out the inflation rate: the percentage change in the index from one period to the next.

In practice the basket is updated every so often, as spending habits change, but it is held fixed between updates.

Quick check

Tap an answer to check it.

The index is 100 in the base year and 112 now. How much have prices risen?
Show answer
12%. (112 − 100) ÷ 100 = 12%.

Why it matters

The inflation figure in the news usually comes from this index. It is used to adjust wages, pensions and benefits, and to tell whether savings or pay are really growing.

Worked example

A tiny economy. The basket is 5 loaves of bread and 2 bus tickets.

Year	Bread	Bus ticket	Basket cost	Index (year 1 = 100)
1	2.00	3.00	5×2 + 2×3 = 16	100
2	2.20	3.00	5×2.2 + 2×3 = 17	17 ÷ 16 × 100 = 106.25

Inflation from year 1 to year 2 is (106.25 − 100) ÷ 100 × 100 = 6.25%. Bus tickets did not change at all; the index still rose because bread is a big part of the basket.

Common mistake

Reading the index level as the inflation rate. An index of 106.25 does not mean prices rose 106%. It means prices are 6.25% above the base year. Inflation is always the change between two index numbers.

Key terms

consumer price index (CPI): cost of a basket of goods, held fixed between updates, compared with a base year
base year: the year the index is set to 100
inflation rate: percentage change in the price index from one period to the next

Practise the key terms

Tap a card to turn it over. 3 cards.

Front	Back
consumer price index (CPI)	cost of a basket of goods, held fixed between updates, compared with a base year
base year	the year the index is set to 100
inflation rate	percentage change in the price index from one period to the next

Practice

Quick quiz

Tap an answer to check it.

In the base year, what is the value of the index?
Show answer
100. Base-year cost ÷ base-year cost × 100 = 100.
The index goes from 200 to 210. What is the inflation rate?
Show answer
5%. (210 − 200) ÷ 200 × 100 = 5%.

Work it through

A basket holds 3 coffees and 1 book. Last year a coffee cost 2.00 and a book 10.00. This year a coffee costs 2.50 and a book 11.00. Use last year as the base year.

Basket cost last year
Basket cost this year
Index this year
Inflation rate (%)

In short

Inflation is a rise in the general level of prices.
A price index tracks the cost of a basket over time; the basket is held fixed between updates.
Index = cost now ÷ cost in base year × 100.
Inflation is the percentage change between two index values.

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Why is the basket held fixed between updates?
Show answer
So that only price changes move the index, not changes in what people buy.
The index is 150 one year and 165 the next. What is inflation?
Show answer
10%, because (165 − 150) ÷ 150 × 100 = 10.
If one price in the basket stays flat, can the index still rise?
Show answer
Yes. Other prices in the basket can rise and push the total up.