Explore the connection between the economic indicators and real-world issues. These lessons typically can be done in one class period.

KEY CONCEPTS

Consumer Price Index (CPI), Costs, Fiscal Policy, Full Employment, Inflation, Monetary Policy, Real Gross Domestic Product (GDP), Unemployment

Current Key Economic Indicators

as of May 5, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.

Employment and Unemployment

Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent...


Information for Teachers

All paragraphs in italics will not appear in the student version of the inflation case study. The original press release can be found at .

This lesson uses several charts and tables. You may use these files to create student reproducables or overhead transparencies for use in your classroom.

Announcement

The consumer price index (CPI) during the month of April decreased by .4 percent (four-tenths of one percent). The rate of increase in the consumer price index over the past twelve months has been 2.6 percent.

In April, the core consumer price index, which excludes energy and food prices, increased by .2 percent (two-tenths of one percent). The core index has increased by 2.3 percent over the last twelve months.

Information for Teachers

All paragraphs in italics will not appear in the student version of the inflation case study. The original press release can be found at . Goals of 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 compares the prices of a set of goods and services relative to the prices 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.

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 .4 percent following a .6 percent increase in March and an increase of .4 percent in February. In April, energy prices continued their rapid increases that began in February.

The annual rate of change over the last three months was an increase of 5.7 percent. Over the last 12 months, we experienced an increase in prices of 2.6 percent. Annual overall inflation rates from 2003 through 2006 were 2.3, 2.7, 3.4 and 3.2 percent.

The core rate of inflation (.2 percent in April) consists of 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 slight increase in the April index compares to .1 percent in March and .2 percent in February. Core prices increased more slowly in the last two months than the overall index due to the rapid increases in prices of energy. The annual rate of increase in prices of energy over the last three months was 43.3 percent.

Extra attention is given by forecasters and policy makers to the core index as it tends to reflect more lasting trends in prices and therefore expectations of future rates of inflation. Increases in energy prices over the last several years have caused other prices to increase more rapidly than they otherwise would have. As energy prices have increased, the core index has continued to gradually rise.

Food and beverage prices increased at .4 percent in April, a bit less than in recent months. Housing prices increases were modest. Apparel prices fell. Transportation prices rose by 1.2 percent reflecting the increase in gasoline prices. Prices of recreation remained steady and education and communication prices rose a bit less than recent rates.

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 years.

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, but one can still see an upward trend.

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 as high, and they are not, when compared to those of the past thirty years. However, the last two years are above the average of a bit less than 2.4 percent in the previous four years. The recent core rates have also 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.

The Consumer Price Index

The seasonally adjusted consumer price index in April was 201.7. The price index was equal to 100 during the period from 1982 to 1984. The years of 1982 to 1984 are described as the base period. 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 105.999 percent, that is from 100 to 205.999. A typical consumer good that cost one dollar in 1982 to 1984 now costs $2.06.

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 205.999, compared to 205.146 in March. The decrease in prices from March to April was (205.999 – 205.146) / 205.146 = -.004. That means a monthly deflation rate of .4 percent or four-tenths of one percent.

To convert this into an approximate annual rate, you can simply multiply by 12. The approximate annual inflation rate is (-.4) (12) = 4.8 percent.

Month

Price Level

Monthly Inflation Rate

March 205.999 205.999 - 205.146 = .004 or .4%       205.146
February 205.146

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. The idea is to measure changes in prices, not in the quantities purchased or in total spending. Thus we use only a single market basket. Most commonly that market basket is a market basket in the original year. But there is no reason that the market basket has to be the original one. There is a reason that the market basket is held constant.

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 .

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

[1.The correct answer is decreased. There are two primary ways to make the calculation. Prices have slightly more than doubled. Income in this case has increased by one-third. Thus, real income has decreased as prices have increased by more than nominal (using current prices) income.

A second method is that one could divide the current nominal income by 2.06 to get the current income in 1983 dollars. That is the real income. The result is that the current real income is $19,417. Thus real income has decreased from $30,000 to $19,417.

2. The correct answer is not changed. Again there are two ways to arrive at the answer. Prices increased by 10 percent. GDP increased by 10 percent. Therefore, real GDP did not change.

A more exact calculation is to calculate real GDP in both cases. In the first year, real GDP equals $10 trillion / 2.00 = $5 trillion in the base year's dollars. In the second year, real GDP equals $11 trillion / 2.20 = $5 trillion. Below another measure, the GDP price index, is discussed and it is the one that is actually used in relationship to GDP.]

Causes of Inflation

[1.The correct answer - Increases in demand will cause prices to rise at the same time quantity is increasing. If demand is rising more rapidly than supply in most markets, most prices will be rising and output will be increasing.

If the cause of inflation were decreases in supply, output would be falling.

2.The correct answer - Decreases in supply will cause prices to rise while at the same time output is falling. If the cause of inflation is an increase in demand, then output should be increasing.]

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 . It is the increases in costs that 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."

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.

Discussion questions

[Note to teachers – This is a good opportunity to ask students to discuss each possible cost of inflation. You might divide the class into five small groups and ask each to select one of the above costs, prepare an example that will illustrate the cost, and then present the examples to the rest of the class.]

Full employment

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as the 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 4.0 and 4.7 or 4.8 percent of the labor force being unemployed. That is if unemployment were to fall to 4.0 percent of the labor force or below, there will increased upward pressure on wages and that may cause prices to begin to increase. If unemployment were 6.0 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