Price index

Measuring inflation requires the use of a price index. It is a way to determine the difference between the price of today's goods with a base year, for example we would like to measure how much the value of things increased from our base year of 2000 to this present year. A price index is the total value of a shopping cart of goods relative to a base year for comparison. To determine how much the price has changed from 2000 to 2007, we will add up the total price of goods we bought in 2007 and divide it with our base year in this case, 2000.

 

2007 (current year)                2000 (base year)
       $1,350           divided by         $1,000
 
                                       multiplied by 100
     
our price index is 135  (prices has increased 35% from 2000 to 2007)
                                  given that the base year is always 100


Using a price index is a good way to gauge current inflation levels, it also functions as an early warning tool if prices are way far from equilibrium and a market correction might be underway. However, as the name implies, the index measures only the surface or what is visible within the bounds of mathematics. It doesn't measure human satisfaction whether the reason for the increase in price is because of an improvement in quality of the good or a service.
In that case, it should cancel the increase in price as an improvement in quality doesn't really result in a change of the  cost of living.

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