Announcement

The consumer price index (CPI) during the month of April increased by .6 percent (six-tenths of one percent). The rate of increase in the consumer price index over the past twelve months has been 3.5 percent.

In April, the core consumer price index, which excludes energy and food prices, increased by .3 percent (three-tenths of one percent). The core index has increased by 2.3 percent over the last twelve months.

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 fixed set of goods relative to the cost of those same goods in a previous month or year. Changes in the prices of those goods approximate changes in the overall level of prices paid by consumers.

The core consumer price index is the average price of the same set of goods and services, without including food and energy prices, relative to the price of the set without food and energy prices in a previous month or year.

Data Trends

In April, the consumer price index increased by .6 percent, after increasing .4 percent in March and .1 percent in February. In April, energy prices increased once again. Price indexes for transportation and apparel also rose.

The annual rate of change over the last three months was an increase of 4.1 percent and over the last 12 months, an increase of 3.5 percent. Annual inflation rates from 2002 through 2005 were 2.4, 1.9, 3.3 and 3.4 percent.

The core rate of inflation (increased by .3 percent in April) represents changes in 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 increased April index compares to .1 and .3 percent increases in the core rate of inflation in each of the previous two months. Core prices increased more slowly in the last two months than the overall index due to rises in prices of energy. The annual rate of increase in prices of energy over the last three months was 16.9 percent.

Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices. This month's results provide some evidence that the increase in energy prices over the last several years has not significantly influenced rates of increases in all other prices, but may be beginning to have an upward pressure on other prices. The rapid rise in energy prices may eventually have a significant effect on all other prices in the economy.

Graph 1

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 one over the last several months. It is however difficult to tell what the trend over a longer period of time has been.

Figure 2 shows the changes in the core index compared to the changes in the overall CPI. Obviously the changes in prices other than energy and food have been significantly smaller than the changes in the overall index.

Graph 2

Figure 3 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, prior to the last few months, 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 and the exercises at the end of this case.

Graph 3

The Consumer Price Index

The seasonally adjusted consumer price index in April was 201. The price index was equal to 100 during the period from 1982 to 1984. The appropriate interpretation of the index is that prices in the market basket of goods and services purchased by the typical consumer increased from the 1982-1984 period to April, 2006 by 101 percent. A typical consumer good that cost one dollar in 1983 now costs $2.01.

Inflation is announced and reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in April was 201, compared to 199.8 in March. The increase in prices from April to March was (201 - 199.8) / 199.8 = .006. That means a monthly inflation rate of .6 percent or six-tenths of one percent.

To convert this into an approximate annual rate, you can simply multiply by 12. This provides us an annual inflation rate of (.6) (12) = 7.2 percent.

Table 1
Month Price Level Monthly Inflation Rate
April 201
201 - 199.8 = .006 or .6%

199.8
March 199.8

How the CPI is Calculated

Assume that there are only three goods (instead of goods and services in over 200 categories in the actual calculation) included in the typical consumer's purchases and, in the base or the original year, the goods had prices of $10.00, $20.00, and $30.00. The typical consumer purchased ten of each good.

In the current year, the goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good.

The CPI for the current year would be the quantities purchased in the market basket in the base year (ten 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 [(10 x $11) + (10 x $24) + (10 x $33)] / [( 10 x $10) + (10 x $20) + (10 x $30)] = $680 / $600 = 1.133. That is, prices in the current year are 1.133 times the prices in the original year. Prices have increased on average by 13.3 percent. The quantities are the base year quantities in both the numerator and the denominator.

By convention, the indexes are multiplied by 100 and reported as 113.3 instead of 1.133.

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 base-year index then is 1.00; or 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, other transportation prices, medical, dental, and legal services and hundreds of other 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 in the sample. Almost 80,000 prices in 87 urban areas across the country are sampled by Bureau of Labor Statistics professionals. Visits and phone calls are made to thousands of households and thousands of retail stores and offices.

For more information on the Bureau of Labor Statistics, visit [EEL-link id='1222' title='www.bls.gov' ] .

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 %

CPI Interactive Exercise

CPI Interactive Activity

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 and is more appropriate to use in calculating real GDP than the CPI, which measures changes in consumer prices alone.

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." ([EEL-link id='1271' title='www.bls.gov/cpi/cpisapage.htm' ] )

Costs of Inflation

Understanding the costs of inflation is not an easy task. There are a variety of myths about inflation. There are debates among economists about some of the more serious problems caused by inflation.

A number of exercises in National Council on Economic Education publications, student workbooks, and textbooks should help students think about the consequences of inflation.

  1. High rates of inflation mean that people and business have to take steps to protect their financial assets from inflation. The resources and time used to do so could be used to produce goods and services of value. Those goods and services given up are a true cost of inflation.
  2. High rates of inflation discourage businesses planning and investment as inflation increases the difficulty of forecasting of prices and costs. As prices rise, people need more dollars to carry out their transactions. When more money is demanded, interest rates increase. Higher interest rates can cause investment spending to fall, as the cost of investing increases. The unpredictability associated with fluctuating interest rates makes customers less likely to sign long-term contracts as well.
  3. The adage "inflation hurts lenders and helps borrowers" only applies if inflation is not expected. For example, interest rates normally increase in response to anticipated inflation. As a result, the lenders receive higher interest payments, part of which is compensation for the decrease in the value of the money lent. Borrowers have to pay higher interest rates and lose any advantage they may have from repaying loans with money that is not worth as much as it was prior to the inflation.
  4. Inflation does reduce the purchasing power of money.
  5. Inflation does redistribute income. On average, individuals' incomes do increase as inflation increases. However, some peoples' wages go up faster than inflation. Other wages are slower to adjust. People on fixed incomes such as pensions or whose salaries are slow to adjust are negatively affected by unexpected inflation.

Full employment

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as full employment rate of unemployment. If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. If unemployment rises to a very high rate, there will downward pressure on wages and prices or wages and prices will remain steady. In the middle is a level, or more likely a range, where there is not pressure on wages and prices to rise or fall.

Economists do not know for certain what that unemployment rate is, and even if they did, it does change over time. A current consensus estimate is that the full employment rate of unemployment is currently between 4.5 and 5.0 percent of the labor force being unemployed. That is if unemployment were to fall to 4.0 percent of the labor force, there will increased upward pressure on wages and that may cause prices to begin to increase. If unemployment were 6 percent, workers competing for jobs may cause wages to fall. Costs of producing fall and prices may fall. Or at least not increase as rapidly.

Questions