Focus on Economic Data: The Inflation Rate - May 18, 2004
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The consumer price index (CPI) during the month of April increased by .5 percent (one-half of one percent). The rate of increase in the consumer price index over the past twelve months has been 3.7 percent.
In April, the core consumer price index, which excludes energy and food prices, did not change from March. The core index has increased by 2.2 percent over the last twelve months.
|Energy or food prices must be increasing rapidly||Energy or food prices must be decreasing rapidly||Energy or food prices could be increasing or decreasing|
Goals of the Case Study
The goals of the Inflation Case Studies are to provide teachers and students:
- access to easily understood, timely interpretations of monthly announcements of rate of change in prices in the U.S. economy;
- descriptions of major issues surrounding the data announcements;
- brief analyses of historical perspectives;
- questions and activities to use to reinforce and develop understanding of relevant concepts; and
- a list of publications and resources that may benefit classroom teachers and students interested in exploring inflation.
Definitions of Inflation
Inflation is a continual increase in the overall level of prices. It is an increase in average prices that lasts at least a few months. The most widely reported measurement of inflation is the consumer price index (CPI). The CPI measures the cost of a set of goods and services relative to the cost of those same goods and services in a previous month or year. Changes in the prices of those goods and services approximate changes in the overall level of prices paid by consumers.
In April, the consumer price index increased by .5 percent, after increasing .6 percent in March and by .4 percent in February. In April, energy prices increased rapidly for the third month in a row and food prices were up by 1.1 percent. Price indexes for apparel fell.
The .5 percent increase continues a series of relatively large increases in the CPI. The annual rate of increase over the last three months was 6.2 percent and over the last 12 months, 3.5 percent. Annual inflation rates during all of 2002, 2003, and 2004 were 1.6, 2.3 and 2.7 percent.
The core rate of inflation (unchanged in April) represents the consumer price index without the influences of changes in the prices of food and energy, which can fluctuate widely from month to month. The constant April index compares to a .4 percent increase in the core rate of inflation in March and .3 percent in February. Core prices increased more slowly in those months than the overall index due to the rapid rises in prices of energy. Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices.
In April, press coverage focused on the steady core index and emphasized that in spite of the rise in the overall index, inflationary pressures, at least as measured by the core index, are reduced.
Figure 1 shows recent inflation data reported for each month. It is obvious that the monthly inflation figures change a great deal from one month to the next. However, the trend has been an increasing trend over the last five months. It is however difficult to tell what the trend over a longer period of time has been.
Figure 2 shows annual rates of inflation from the 1970s to now. Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is low. Few observers would describe the most recent rates as high and they are not, when compared to those of the past thirty years. However, the recent rates have been increasing and that has caused some concern. See the most recent Federal Reserve case study.
The Consumer Price Index
The seasonally adjusted consumer price index in April was 194.2. The price index was equal to 100 during the period from 1982 to 1984. The interpretation is that prices in the market basket of goods and services purchased by the typical consumer increased from the 1982-1984 period to April 2005 by 94.2 percent. A typical consumer good that cost one dollar in 1983 now costs $1.94.
Can you calculate the monthly increase in prices given the CPI in April and in March? In March, the CPI equaled 193.2.
The answer is “It was .5 percent.” Inflation is usually reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in April was 194.2, compared to 193.2 in March. The increase in prices from March to April was (194.2 – 193.2) / 193.2 = 0.0052 or a monthly inflation rate of .52 percent. It is reported to the nearest one-tenth of a percent, in this case, .5 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (.5) (12) = 6 percent. A slightly more accurate measurement of the annual inflation rate is to compound the monthly rate, or raise the monthly rate of increase, plus one, to the 12 th power. The result is an annual rate of inflation of 6.4 percent.
|Month||Price Level||Monthly Inflation Rate||Annual Inflation Rate|
|1.005212 = 1.064 or 6.4 %|
How the CPI is Calculated
Assume that there are only two goods included in the typical consumer's purchases and, in the base or the original year, each goods has a price of $10.00. Each consumer purchases one of each good.
In the current year, the goods' prices are $11 and $12. The index for the current year would be the quantities purchased in the market basket in the base year (one each of each good) times their prices in the current year divided by the quantities purchased in the market basket in the base year times their prices in the base year.
Thus ( 1 x $11 + 1 x $12 ) / ( 1 x $10 + 1 x $10 ) = $23 / $20 = 1.15. That is, prices in the current year are 1.15 times the prices in the original year. Prices have increased on average by 15 percent. That is true. The price of the first good increased by 10 percent. The price of the second good increased by 20 percent. By convention, the indexes are multiplied by 100 and reported as 115 instead of 1.15.
The base year index simply divides the prices in the base year (times the quantities in the base year) by the prices in base year (times the quantities in the base year). The index then is 1.00; multiplied by 100 equals 100.
How the CPI Data are Collected
The Bureau of Labor Statistics samples the purchases of households representing 87 percent of the population. The Consumer Price Index measures prices of goods and services in a market basket of goods and services that is intended to be representative of a typical consumer's purchases. Forty-one percent of the market basket is made up of goods that consumers purchase. The other fifty-nine percent includes services.
Goods and services sampled include food, clothing, housing, gasoline, transportation, medical, dental, and legal services and hundreds of retail goods and services. Taxes associated with the purchases are included. Each item is weighted in the average according to its share of the spending of the households included. Almost 100 urban areas are sampled by Bureau of Labor Statistics professionals including visits and phone calls to 50,000 households and almost 25,000 retail stores and offices.
For more information on the Bureau of Labor Statistics, visit [EEL-link id='1222' title='www.bls.gov' ] .
Causes of Inflation
Over short periods of time, inflation can be caused by increases in costs or increases in spending. Inflation resulting from an increase in aggregate demand or total spending is called demand-pull inflation . Increases in demand , particularly if production in the economy is near the full-employment level of real GDP, pull up prices. It is not just rising spending. If spending is increasing more rapidly than the capacity to produce, there will be upward pressure on prices.
Inflation can also be caused by increases in costs of major inputs used throughout the economy. This type of inflation is often described as cost-push inflation . Increases in costs push prices up. The most common recent examples are inflationary periods caused largely by increases in the price of oil. Or if employers and employees begin to expect inflation, costs and prices will begin to rise as a result.
Over longer periods of time, that is, over periods of many months or years, inflation is caused by growth in the supply of money that is above and beyond the growth in the demand for money.
Inflation, in the short run and when caused by changes in demand, has an inverse relationship with unemployment. If spending is rising faster than capacity to produce, unemployment is likely to be falling and demand-pull inflation increasing. If spending is rising more slowly than capacity to produce, unemployment will be rising and there will be little demand-pull inflation.
That relationship disappears when inflation is primarily caused by increases in costs. Unemployment and inflation can then rise simultaneously.
Other Measures of Inflation
The GDP price index (sometimes referred to as the implicit price deflator). The GDP price index is an index of prices of all goods and services included in the gross domestic product. The index is a measure that is broader than the consumer price index.
The producer price index . This index measures prices at the wholesale or producer level. It can act as a leading indicator of inflation facing consumers. If the prices producers are charging are increasing, it is likely that consumers will eventually be faced with higher prices for good they buy at retail stores.
A Note on Seasonally Adjusted and Unadjusted Data
"Because price data are used for different purposes by different groups, the Bureau of Labor Statistics publishes seasonally adjusted as well as unadjusted changes each month. For analyzing general price trends in the economy, seasonally adjusted changes are usually preferred since they eliminate the effect of changes that normally occur at the same time and in about the same magnitude every year--such as price movements resulting from changing climatic conditions, production cycles, model changeovers, holidays, and sales.
The unadjusted data are of primary interest to consumers concerned about the prices they actually pay. Unadjusted data also are used extensively for escalation purposes. Many collective bargaining contract agreements and pension plans, for example, tie compensation changes to the Consumer Price Index unadjusted for seasonal variation."
A Market Basket of Goods and Services
The Consumer Price Index measures prices of goods and services in a market basket of goods and services that is intended to be representative of a typical consumer's purchases. The relative importance of each of the categories of goods and services that included in the market basket are as follows.
|Housing||42 %||Recreation||6 %|
|Transportation||17 %||Education and communication||6 %|
|Food and beverages||15 %||Clothing||4 %|
|Medical care||6 %||Other goods and services||4 %|
If inflation is 3 percent a year and average income increases by 5 percent, what has happened to real average income?
- Decreased by 2 percent
- Increased by 2 percent
- Increased by 3 percent
- Increased by 5 percent
Increased by 8 percent
If GDP increases by 3 percent over a year and the GDP price index increases by 4 percent, what has happened to real GDP?
- Decreased by 1 percent
- Increased by 1 percent
- Increased by 3 percent
- Increased by 4 percent
Increased by 7 percent
Suppose the CPI was 150 for April of one year, and was 170 for April of the next year. What is the approximate annual rate of inflation?
- 70 percent
- 20 percent
- 17 percent
- 15 percent
The base year of the CPI is 1982-1984. What has happened to prices since 1970 if the 1970 index was approximately 80 and if the current CPI were 160?
- Increased by 60 percent
- Increased by 80 percent
- Increased by 100 percent
Increased by 160 percent
The consumer price index has increased from 100 to 110 and average incomes have gone from $30,000 to $33,000, what has happened to real income?
- not changed
One cannot tell.
If the consumer price index has increased from 250 to 275 and average income has gone from $30,000 to $36,000, what has happened to real average income?
- not changed
One cannot tell.
An Exercise for Understanding the Definition of Inflation
The following question and answer appeared in a recent publication of a major financial firm.
“Have you experienced inflation recently? How was the inflation caused?
“Answer: Recent increases in gas prices; prices of fruits and vegetables varying with seasons; bathing suits costing more in the spring and summer, movie ticket prices being less or more depending on the area….”
Can you evaluate the question and answer?