Using data from the Bureau of Labor Statistics on the Consumer Price Index (CPI), students investigate the latest release for September 2014. Students will explore what a "good" inflation rate is, and why 0% or deflation is harmful to the economy.

KEY CONCEPTS

Consumer Price Index (CPI), Deflation, Inflation, Macroeconomic Indicators, Macroeconomic Policies, Macroeconomics, Price Stability

STUDENTS WILL

  • Analyze the most current report from the Bureau of Labor Statistics with respect to the Consumer Price Index and its components
  • Understand the rationale for the Federal Reserve target inflation rate of 2%
  • Place the current inflation rate within a larger historical context
  • Evaluate the negative consequences of deflation and its relationship to holding long-term debt

Current Key Economic Indicators

as of November 10, 2014

Inflation

The Consumer Price Index for All Urban Consumers increased 0.1 percent in October on a seasonally adjusted basis. The core inflation rate increased the same amount. For the previous 12 months, the index increased 1.7%, the same rate as reported in the September report.

Employment and Unemployment

According to the October report of the Bureau of Labor Statistics, the unemployment rate fell from 5.9% to 5.8%, and the number of individuals unemployed also decreased. Total nonfarm employment rose by 214,000 in October. Employment gains were concentrated in retail trade, food services and health care.

Real GDP

The advance estimate for real GDP growth in the third quarter of 2014 was 3.5%, a decrease from the revised second quarter growth of 4.6%. Inventory investment reduced third quarter growth, while it added to second quarter growth. In addition, consumer spending increased at a lower rate in the third quarter, compared to the second. Finally, business investment increased in the third quarter, but at a lower rate than in the second quarter.

Federal Reserve

The FOMC believes that the labor market has shown considerable improvement and the risks of inflation rising above its 2% target are low. Therefore, the Federal Reserve announced plans to end its purchase of financial assets. In addition, the federal funds rate will remain at its current low level. However, the FOMC has signaled its willingness to increase the federal funds rate if inflation shows signs of rising above the 2% target.

INTRODUCTION

Every month, the Bureau of Labor Statistics releases the "Consumer Price Index Summary", a comprehensive report on the CPI and inflation rate. Each report provides the current estimates of price level changes for various categories of goods and services, as well as for major metropolitan areas. 

This lesson uses the October 22, 2014, release for September 2014, to explore the relative changes by category, the concept of a target rate of inflation, and the effects of deflation on the economy.

RESOURCES

  • BLS Feature: Focus on Prices and Spending- What Does the Producer Price Index Measure? The BLS breaks down the official definition of the Producer Price Index to clear up common misconceptions about prices, production, and price pass-through within the PPI.
    www.bls.gov/ppi/
  • BLS, Frequently Asked Questions webpage
    Frequently Asked Questions

PROCESS

  1. Refer students to the latest Bureau of Labor Statistics report on inflation for September 2014: www.bls.gov/news.release/pdf/cpi.pdf

    Ask students: What is the inflation rate over the last 12 months? [1.7%.] How has that changed from last month? [It stayed the same.] What categories experienced an increase in inflation? [Shelter and food.] Which experienced a decrease? [Energy.]
     
  2. Point out that an inflation rate of 1.7% is fairly low--below the Federal Reserve's target of 2%. Ask if a 0% inflation rate would be better, or even a negative inflation rate [deflation]. In other words, ask them, wouldn't it be better for the economy if prices didn't increase at all, or actually fell? [They will probably say that this would be better.] Don't give them an answer yet.
     
  3. Ask students why nominal wages increase over time [Answers will vary, but should include productivity gains and compensating workers for the effects of inflation.] If nominal wages increase over time because of inflation, ask students what would happen [theoretically) to nominal wages if prices fell [Wages would fall.]

    NOTE: since wages tend to be "sticky" downwards, nominal wages may not fall immediately, or at all. In this case, employers are faced with receiving lower prices for their goods and services, but wage costs that remained the same. They would respond by reducing their work force in an effort to lower their costs of production.

    Ask students what would happen to the unemployment rate if businesses reduced their costs of labor by decreasing their work force [The unemployment rate would go up.]
     
  4. Tell students to imagine that they borrow money from their parents to buy a car and agree to pay them back $50 a month for 7 years. Further, tell them to assume they have a job that pays them $1,000 a month. After paying their parents, they have $950 to spend on rent, insurance, food, etc. Seven years is a long time, and in that time, their pay will probably increase. Remind students that part of the increase in pay will be because they are more productive, but another part is to compensate them for inflation. Tell them to assume that after a year or so, their pay increases to $1,200 a month. They still owe their parents the $50 a month, so after that payment, they have $1,150 left to spend on other things (which have probably gone up in price due to inflation). With some inflation, borrowers are better off since they are paying back loans with money that is worth less than it is today.

    In contrast, ask them if they would be happy if their income fell from $1,000 a month to $800. They would still owe their parents the $50, but only have $750 left to spend on other things. Make the point that if there is inflation, the real cost of fixed debt payments goes down. Likewise, in a deflationary period, the real cost of fixed debt payments would increase.
     
  5. Show students this graph of historical inflation rates in the U.S.:



    Point out that inflationary periods are indicated by the purple areas above the 0% axis, and deflationary periods are marked by the green areas below the axis. Ask students what they notice about this graph. [The variability of inflation has decreased over time; the incidence of deflation has decreased over time to the extent that after about 1950, it ceased.] Ask students why they think that deflation ceased [Answers will vary--don't address the answers at this point, just accept them.]

    Draw students' attention to the last significant period of deflation--ask if they know what period of history it coincided with [the Great Depression]. Tell them that it wasn't until the 1920's that using credit to make large purchases--taking out a mortgage to buy a house, taking out a car loan--was common.

    Remind them of the points made in #4 above about the real cost of fixed debt obligations. Ask again why they think that deflation effectively stopped at the same time that long-term debit instruments became more common [The widespread use of fixed debt made periods of deflation much more costly, so it was actively avoided by policy makers.]

    NOTE: for middle class families, mortgage debt obligation can be 1/3 of their incomes or more. Having this level of fixed debt obligation in an environment of falling (or stagnant) wages would create financial difficulties for many, leading them to curtail their spending in other areas. Again, even if nominal wages do not fall in the near-term, employers would respond by cutting employment.
     
  6. Remind them that the Federal Reserve has twin objectives of full employment and price stability. Price stability does not mean 0% inflation. In fact, if inflation gets too near to 0%, the Fed's concern is that it devolves into a deflationary spiral. Price stability means that the inflation rate is stable, not that prices themselves are stable, and that the inflation rate is relatively low. Just as full employment does not mean 0% unemployment, price stability does not mean 0% inflation.

ASSESSMENT ACTIVITY

CONCLUSION

Each month, the Bureau of Labor Statistics releases the report on the Consumer Price Index and inflation. The report (released October 22, 2014) indicated that inflation rose 1.7% for the 12-month period ending in September, an annualized rate unchanged from the previous month. 

While many think that a 0% inflation rate, or even deflation, would be beneficial, the negative consequences would be substantial, including declining wages (or higher unemployment), and a reduction in consumer spending as households felt the weight of relatively heavier long-term debt obligations. In fact, historically, policy makers have avoided periods of deflation coinciding with the rise in these fixed-debt instruments.

EXTENSION ACTIVITY

Remind students that the government has fixed debt obligations in the form of government bonds to finance the nation's debt. Ask what the effect on the budget would be if the country entered a deflationary period [Two things would happen: first, the same outcome would occur as with any fixed debt holder--the relative payment on the debt would increase; and second, federal  tax revenues would decrease since household incomes would fall. The budget would be affected on both the revenue side and the spending side.]

EDUCATOR REVIEWS