This lesson focuses on the Consumer Price Index (CPI) and rate of inflation in the U.S. for the month of July, 2012, reported on August 15, 2012, by the U.S. Bureau of Labor Statistics. Students read the BLS report, analyze the meaning of the CPI data, determine the change in consumer prices, and explore the impact of the change in the price level on themselves, their families, consumers, and producers.
- Explain how the consumer price index is determined.
- Identify the current rate and recent changes in the CPI, and rate of inflation in the United States in July, 2012.
- Identify factors that have influenced recent changes in the inflation rate.
- Describe how inflation impacts different groups in the economy.
- Distinguish between the core rate and the more broad measures of inflation.
Current Key Economic Indicatorsas of November 10, 2014
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.
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.
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.
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.
Each month, the U.S. Bureau of Labor Statistics (BLS) releases an estimate of the level of the consumer price index (CPI) and the rate of inflation in the United States for the previous month. The report provides the most recent current and seasonally adjusted consumer price indexes for all urban consumers, urban wage earners, and the chained index, plus a breakdown by major expenditure groups. The BLS also collects price level data for major metropolitan areas and regions.
This lesson focuses on the August 15, 2012, BLS press release of data on the consumer price index for the month of July, 2012.
For the latest updates on U.S. economic indicators, go to:
- EconomicIndicators.gov: http://economicindicators.gov/
- BLS Economic Indicator: www.bls.gov/bls/newsrels.htm#major
- BEA Economic Indicators: www.bea.gov/newsreleases/glance.htm
[NOTE: You can subscribe to receive monthly BLS email news releases. To subscribe, go to the BLS News Service Subscription Page. www.bls.gov/bls/list.htm ]
[NOTE on the CPI and Inflation "Focus on Economic Data" Lessons: During the first semester of the 2012-2013 school year (August- December, 2012), EconEdLink will publish five lessons on "Consumer Price Index and Inflation." During this time period, the Focus on Economic Data lessons will begin with the "basics" in August and progressively focus on more complex data, issues, and comparisons. All monthly lessons will include the current data and significant recent changes.
August: CPI and inflation (deflation) basics: What is the CPI? What is inflation and deflation? How are they measured? What do they mean?
September: Details and issues about the measurements and meaning of the measurements of the price level, adding additional concepts. March: Detailed breakdown of the data by region and other criteria (trends, identifying trends and comparisons of regions and demographic groups).
October: U.S. regional and global price level and inflation comparisons.
- November: The relationships of CPI and inflation data to other economic data, such as GDP, employment. etc. and the business cycle. End of year price level summary and potential issues.
- December: 2012 year-end review.
BLS release of CPI data: August 15, 2012, for the month of July, 2012. Economic News Release: http://www.bls.gov/news.release/cpi.nr0.htm
Economic News Release
BLS "Focus on Spending and Prices": These quarterly reports highlight recent trends in inflation and spending in the U.S. economy.
"The Consumer Price Index.": This article is from the BLS Handbook of Methods, Chapter 17. It talks in great depth about the CPI.
Frequently Asked Questions About the CPI: This site answers FAQ's for those trying to read CPI releases.
CPI Inflation Calculator: This calculator allows users to compare price changes over time due to inflation.
EconomicIndicators.gov: This site provides the latest updates on U.S. economic indicators.
BLS Economic Indicators: This site provides the latest updates on U.S. economic indicators.
Whose Buying Habits Does the CPI Reflect?: This page explains that the BLS measurement of the CPI-U includes all urban consumers, representing about 87 percent of the total U.S. population.
Consumer Price Index for all Urban Consumers: U.S. City Average, by Expenditure Category and Commodity and Service Group. This table explains the current level of the CPI-U.
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-though within the PPI.
BLS, Frequently Asked Questions webpage
Frequently Asked Questions
Key Economic Indicatorsas of August 15, 2012
On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers was unchanged in July, as it was in June. The index for all items less food and energy rose 0.1 percent in July after increasing 0.2 percent in June.
Total non-farm payroll employment rose by 163,000 in July, and the unemployment rate was essentially unchanged at 8.3 percent. Employment rose in professional and business services, food services and drinking places, and manufacturing.
Real gross domestic product -- the output of goods and services produced by labor and property located in the United States -- increased at an annual rate of 1.5 percent in the second quarter of 2012, (that is, from the first quarter to the second quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 2.0 percent.
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee (FOMC) expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.
On August 15, 2012, the U.S. Bureau of Labor Statistics (BLS) reported, "The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in July on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.4 percent before seasonal adjustment."
Thanks to a decrease in energy prices in July, the overall CPI-U did not decrease over the month. Food and some other prices did increase, but not much. What does it mean to you? To better understand this data, it is important to start with a couple of key price level basic concepts.
[Note: Unless specifically referenced, quoted data is directly from the August 15, 2012, BLS announcement. http://www.bls.gov/news.release/cpi.nr0.htm ]
What is the Consumer Price Index?
The Consumer Price Indexes (CPI), reported by the U.S. Bureau of Labor Statistics, part of the U.S. Department of Labor, is a monthly measurement of changes in the prices paid by urban consumers for a representative market basket of goods and services. An increase in the CPI from one month to another over time may be evidence of "inflation" in the price level or a reduction in consumers' purchasing power.
The CPI measures changes in prices over time. By selecting an appropriate base year and setting the index level for that time period at 100, the CPI compares one month's price index level with the base year or any other time period. The current standard reference base period is the average of the period from 1982 to 1984.
To see how the CPI works, you can go to the BLS CPI Calculator. The CPI inflation calculator allows you to calculate the value of current dollars in an earlier period, or to calculate the current value of dollar amounts from years ago. Consumer Price Indexes often are used to escalate or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.
[Teacher Note: Assign the students different time periods to determine the U.S. rates of inflation over those time periods. They may want to investigate to determine factors that may have influenced prices during that time period. Was there economic growth or decline? What was happening in other parts of the world? Was the population growing? Link: http://data.bls.gov/cgi-bin/cpicalc.pl ]
What is Inflation?
Inflation is generally defined as a continual increase in the overall level of prices. It is an increase in average prices that lasts at least a few months. Often, a one month increase in prices is referred to as inflation, but a longer-term upward trend of prices is a more accurate definition. The most widely reported measurement of inflation is the Consumer Price Index (CPI). For this announcement, the BLS reports the CPI-U - the consumer price index for all urban consumers.
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. If the price level of consumer goods and services increases over a period of time, the consumer's purchasing power decreases (assuming, of course, that the consumer's disposable income and spending pattern remain the same).
Just the opposite of inflation, deflation is generally defined as a continual decrease in the overall level of prices. It is a decrease in average prices that lasts at least a few months. If the price level of consumer goods and services decreases over a period of time, the consumer's purchasing power increases (assuming, again, that the consumer's disposable income and spending pattern remain the same.)
Discussion Question: Is this definition what you thought inflation was?
[Teacher Note: BLS web page article Frequently Asked Questions About the CPI provides information for this discussion.]
Who is Included in the Determination of the CPI-U?
The CPI-U refers to all urban consumers. Because the spending patterns of rural, farm and some other groups are not consistent with typical "urban" consumers, the BLS restricts the measurement of the price indexes to urban consumers (CPI-U) or urban wage earners (CPI-W).
The BLS FAQ webpage explains: "The CPI reflects spending patterns for each of two population groups: all urban consumers and urban wage earners and clerical workers. The all urban consumer group represents about 87 percent of the total U.S. population. It is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers. Not included in the CPI are the spending patterns of people living in rural nonmetropolitan areas, farm families, people in the Armed Forces, and those in institutions, such as prisons and mental hospitals. "Link: http://www.bls.gov/cpi/cpifaq.htm#Question_3
Bureau of Labor Statistics Announcement
Consumer Price Index and Inflation - July, 2012
Released July 15, 2012
"The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in July on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.4 percent before seasonal adjustment."
"Over the last 12 months, the all items index increased 1.4 percent before seasonal adjustment. Major indexes posted small movements in July, with a 0.3 percent decline in the energy index offsetting 0.1 percent increases in the indexes for food and all items less food and energy."
A brief explanation of seasonal adjustment from the BLS: “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. Snow shovel and ice-melt demand will increase in the winter. Bathing suit demand will increase in the spring and summer. This demand may result in higher seasonal prices.
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 before adjustment for seasonal variation.”
[Teacher Note: Ask your students to identify goods and services that are affected by seasonal changes. Their lists may include bathing suits, sun tan lotion, ice cream, winter coats, ski equipment, lawn care products, school supplies, etc. They should be able to identify how the demand for some goods and services is impacted be seasonal changes, such as the weather.]
In the announcement, as usual, the BLS quickly identified energy prices as a primary factor in the movement of the overall price level. In this case, influencing the overall level to decline in July.
"Within energy, declines in the indexes for electricity, natural gas, and fuel oil more than offset a small increase in the gasoline index. Within the food component, the food at home index was unchanged with major grocery store food group indexes mixed, while the food away from home index increased."
Because energy and food prices tend to fluctuate more than most other consumer goods and services prices, the BLS also reports an "index for all items less food and energy." This is commonly referred to as the "core index" or "core CPI."
"The index for all items less food and energy rose 0.1 percent in July, ending a streak of four consecutive 0.2 percent increases. The shelter index rose 0.1 percent for the second month in a row."
The BLS also reports the change in the price level over the preceding 12-month period, both the all items and core indexes. "The 12-month change in the index for all items was 1.4 percent in July. This compares to 1.7 percent in June and is the smallest 12- month change since November 2010. The index for all items less food and energy rose 2.1 percent for the 12 months ending July, a slight decline from the 2.2 percent figure in June and its smallest increase since October 2011." Again, energy prices were a significant factor in the recent period.
Note: The 12-month index is not seasonally adjusted, because it includes all seasons and seasonal events.
[Teacher Note: For student discussion, ask: What price changes have you noticed over the previous few months? Gasoline? Food? Other consumer goods? What about housing or rent? What was your holiday shopping experience in December 2011?]
What was the Nominal Level of the CPI-U in December 2010?
The level of the CPI is reported in "nominal" terms or current dollar values. This is also referred to as the "current" dollar level. On August 15, the CPI reported, "The Consumer Price Index for All Urban Consumers (CPI-U) increased 1.4 percent over the last 12 months to an index level of 229.104 (1982-84=100). For the month, the index decreased 0.2 percent prior to seasonal adjustment."
The BLS also measures the Consumer Price Index for All Urban Wage Earners and Clerical Workers (CPI-W) for a more narrow urban population group - wage earners. The CPI-W is most commonly used for employment contract wage escalations (often called cost of living increases). "The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) increased 1.3 percent over the last 12 months to an index level of 225.568 (1982-84=100). For the month, the index decreased 0.2 percent prior to seasonal adjustment."
The BLS explains, “The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) is based on the expenditures of households included in the CPI-U definition that also meet two requirements: more than one-half of the household's income must come from clerical or wage occupations, and at least one of the household's earners must have been employed for at least 37 weeks during the previous 12 months. The CPI-W population represents about 32 percent of the total U.S. population and is a subset, or part, of the CPI-U population.”
The Chained CPI - the C-CPI-U
The third CPI measurement reported monthly is the C-CPI-U, a "chained" price index. According to the BLS, the advantage of the C-CPI-U is that it uses a formula that includes "expenditure data in adjacent time periods in order to reflect the effect of any substitution that consumers make across item categories in response to changes in relative prices. The new measure is designed to be a closer approximation to a "cost-of- living" index than the existing BLS measures." In other words, it more accurately reflects actual consumer decisions, especially substitution, over shorter time periods.
In July, 2012, the C-CPI-U "increased 1.4 percent over the last 12 months. For the month, the index decreased 0.2 percent on a not seasonally adjusted basis." The C-CPI-U was designed as a way to adjust for consumer substitution over time periods. When consumers substitute one product for another, the relative prices may be different. When the price of a good or service increases (or decreases), consumers may choose to substitute another good or service.
Substitute: A good or service that may be used in place of another good or service; examples include tap water for bottled water (or vice versa) and movies for concerts (or vice versa).
[Teacher Note: Ask your students if they have substituted one good for another because of an increase in price or the difference in prices. For instance, have they stopped going to movies or purchasing a particular name brand?]
Typically, a consumer will substitute one good for another good based on their relative prices. If consumers substitute one good for another good that is part of the market basket, it is not reflected in the CPI-U. The C-CPI-U is adjusted for these changes.
The level of the CPI-U in July, 2012, was 229.104. That means a market basket of goods that cost $100 in 1982-1984 (the base year period) now costs about $229.10. That same basket cost just $225.92 in July of 2011. Over the year, the cost (average across the nation) of the market basket increased by $3.18 - about 1.4 percent. If your monthly income has increased by about $3.18 in the past year, your income has kept-up with inflation (at least with the price of this market basket of goods and services.) Remember, this is a "sample" market basket. If your spending habits are significantly different from the "average" the impact of inflation on you is different. If you spent more than the average on food away from home in July, the price level change affected you more.
[Teacher Note: To review the recent history of the CPI-U from 1990 to the present time, go to the BLS webpage: http://data.bls.gov/cgi-bin/surveymost ]
Real vs. Nominal Data Measurements
In many cases, data should be adjusted for a change in the price level to make comparisons over time more meaningful. The term nominal is used to refer to a measurement in current dollars. To adjust for inflation and determine a real or constant dollar value, the nominal value is adjusted by the price level change. A measurement such as gross domestic product in nominal terms refers to the measurement at current dollars (prices.) To compare GDP in two years, the rate of inflation between the years must be subtracted to determine the real change.
The same is true for income and purchasing power. Suppose Mr. Jones made $50,000 in 2010 and $52,000 in 2011. His income increased by $2,000 or 4 percent from 2010 to 2011. If the rate of inflation between 2010 and 2011 was 5 percent, Mr. Jones' purchasing power actually decreased by 1 percent. His 4 percent increase in income did not purchase the same amount of goods and services as it did in the previous year. Inflation reduced his purchasing power, even though he had more income.
[Teacher Note: Emphasize the meaning of "real income" or "real GDP" as measurements of value adjusted for inflation and the importance of adjusting for inflation when making comparisons over time.]
The CPI Market Basket
The CPI market basket represents all the consumer goods and services purchased by urban households. Price data are collected for over 180 categories, which BLS has grouped into 8 major groups. These major groups, with examples of categories in each, are as follows:
- Food and beverages (ham, eggs, carbonated drinks, coffee, meals and snacks)
- Housing (rent of primary residence, fuel oil, bedroom furniture)
- Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
- Transportation (new vehicles, gasoline, tires, airline fares)
- Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
- Recreation (television sets, cable TV, pets and pet products, sports equipment, admissions)
- Education and communication (college tuition, postage, telephone services, computer software and accessories)
- Other goods and services (tobacco and smoking products, haircuts and other personal care services, and funeral expenses)
Figure 1, below, shows the July, 2012, price level data for the primary categories in the CPI-U market basket, including the change from June to July, 2012, and for the most recent 12-month period.
Note the categories that increased or deceased more or less than the average in July or over the past twelve months.
The CPI is a Weighted Index
Because each product group (energy, food, etc.) represents a different portion of an average consumer's spending pattern, each category of given a "weight" or what the BLS calls "relative importance." These weights are based on typical percentages and, in this case, national averages. Figure 2, below, shows the weights assigned by the BLS to major product groups.
Weights for individuals may not follow this same pattern. Some people pay a larger portion of their income for rent or their mortgage than others. A high school student may spend a much greater portion of his or her income on gasoline, clothes and food than some other groups. A retired person who has paid-off a mortgage may pay a much smaller portion of his or her income for housing than other groups.
[Note: The above data are national averages. The category weights differ from region to region. For instance, when the weight for food and beverage was 15.4 in the Boston region, it was 16.0 in the Cincinnati region. Food and beverage costs are a slightly larger portion of the market basket of the index in Cincinnati than in Boston.]
[Teacher Note: It may be interesting for students to determine their own "market basket." How do they spend their income? What percentages of their income do they spend on gasoline, clothes, entertainment, etc.?]
Figure 3, below, shows the changes in the monthly CPI-U price level from 2002 through July, 2012. Note the several periods of higher inflation, the periods of relative stability, and the not-so-common and shorter periods of declining prices. The key variable over this time has been the more volatile increases and decreases in energy prices, especially gasoline.
The recent period of relatively low inflation may be the result of the 2008-2009 recession and continuing slow growth.
Note the last four months of the CPI data changes in Figure 3. Three of the four months saw no change and May had a 0.3 percent decrease. The overall price U.S. level has remained very stable over that period. Gasoline prices have bounced up and down over the months, but the overall price level has met the Federal Reserve System's goal of "maintaining purchasing power." Despite the many stimulus programs to grow the economy, there has not been serious pressure in prices.
The Consumer Price Index—Why the Published Averages Don't Always Match An Individual's Inflation Experience?
"The Consumer Price Index (CPI) is a measure of the average change in prices paid by urban consumers for a market basket of goods and services. Because the CPI is a statistical average, it may not reflect your experience or that of specific families or individuals, particularly those whose expenditure patterns differ substantially from the "average" urban consumer." http://www.bls.gov/cpi/cpifact5.htm
Measuring Consumer Prices
There are several measurements or reported levels of the CPI. They are:
- CPI: A measure of the average change in prices over time of goods and services purchased by households.
- CPI-U: The Consumer Price Index for All Urban Consumers. This includes approximately 87 percent of the total population, including wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the self-employed, short-term workers, the unemployed, retirees, and others not in the labor force.
- CPI-W: The Consumer Price Index for Urban Wage Earners and Clerical Workers. This includes households of wage earners and clerical workers, representing approximately 32 percent of the total population.
- C-CPI-U: The Chained Consumer Price Index for All Urban Consumers. This measurement uses a formula that reflects the substitutions consumers make in response to changes in relative prices.
- Core CPI: The average price of the same set of goods and services, without some of the more volatile components, such as food and energy prices.
How is the CPI 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, $20, and $30. The typical consumer purchased ten of each good. Total cost of this "market basket" in the base year was $600.
In the current year, the three goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good. The total current price of this "market basket" is $622, but this would not be an accurate way to compare the "price level." An accurate comparison has to assume a constant pattern of purchasing.
The determination of the CPI for the current year uses 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.
Figure 4, below, shows how the change in the CPI was determined for July, 2012.
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.
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.
Demand-pull example: If the economy and the population are growing at a fast pace, food and energy supplies may not be increasing fast enough. Prices will rise because of the "pull" of increased demand.
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.
Cost-push example: If OPEC and other oil producers restrict their output, oil prices will rise. Because oil is an important resource for the production of many consumer goods, the prices of those goods will rise because of the increased cost of production.
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.
The 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.
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.
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.
The adage "inflation hurts lenders and helps borrowers" really 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.
Inflation reduces the purchasing power of money. If your income is fixed or does not increase as much as the rate of inflation, you cannot purchase as many goods and services this year as you could last year. Your real income decreases.
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.
Inflation redistributes income. Those who owe money (borrowers) can repay it with inflated dollars (if their income increased to keep up with the inflation). Those who are owed money (lenders) receive dollars with less value when loans are repaid. Hopefully, the principal and interest received have at least the same purchasing power as the money loaned. In this situation, income is redistributed from lenders to borrowers.
Other BLS Price Indexes
The Bureau of Labor Statistics publishes several other price indexes which can be used by consumers, government agencies and, private companies for budgeting and planning.
- Producer Price Indexes The Producer Price Indexes (PPIs) are a family of indexes that measure changes in the selling prices received by domestic producers of goods and services. They formerly were referred to as Wholesale Price Indexes. When the PPIs are released, the news media will most often report the percentage change in the index for Finished Goods. Producer Price Indexes also can be used in escalation contracts. A fact sheet named Escalation Guide for Contracting Parties further explaining the PPI details is available.
- Import and Export Prices The International Price Program measures change in the prices of imports and exports of nonmilitary goods between the United States and the rest of the world.
- Employment Cost Trends This program publishes quarterly statistics that measure change in labor costs (also called employment costs or compensation costs) over time; quarterly data measuring the level of costs per hour worked are also published. Indexes are available for total labor costs, and separately for wages and salaries and for benefit costs. Some information is available by region, major industry group, major occupational group, and bargaining status.
- Contract Escalation Consumer Price Indexes, Producer Price Indexes, and the Employment Cost Index may be used to escalate contracts.
- Consumer Price Indexes (CPIs) Consumer Price Indexes as published by individual countries, unadjusted for comparability, as well as harmonized indexes for a smaller selection of countries, are available on the International Labor ComparisonsTables page.
[Teacher Note: Students should be able to identify factors that may influence the prices of the goods and service they purchase. As a summary discussion (or written assignment), have them choose a good or service and identify the factors influencing the price over time. What are the possible demand-pull factors (income or some other change in demand) and cost-push factors (costs of inputs)?]
[Teacher Note: Student should be able to identify how inflation or a rise in some prices impacts different demographic groups - teens, families, older adults.]
Short Answer Essay Questions:
1. What is the different between demand-pull and cost-push inflation?
[Demand pull inflation results from increased demand for goods and services. Cost push inflation results from rising prices for productive resources. If commodity prices force producers to raise the prices of consumer products, that is an example of 'cost push.' If population increase and other factors result in a greater number of people wanting a product, it may be an example of 'demand pull.']
2. Which measurement, the CPI-U or the core rate is the most meaningful measurement of inflation?
[Those concerned with the prices they currently pay for all goods and services, including energy and food, may see the CPI-U as more important. These are prices actually paid from one time to another. Consumers will typically base their spending plans on prices they currently pay or expect to pay. Inflation creates uncertainty about future purchasing power. Policy planners may look more at the core rate because energy and food prices have tended to go up and down over time, even if the longer term trend is upward. Planners must, necessarily, look at longer trend periods.]
3. Explain how a borrower can actually benefit from inflation?
[Assuming that the borrower’s income rises with the inflation, the borrower is repaying a loan with cheaper dollars. Suppose she earned $10 an hour in year 1 and borrowed $100 for one year at 5 percent interest. In year 2, her income increased to $11 an hour. If she repaid the loan in year 2 ($100 plus $5 interest), it took her fewer hours to earn the income to repay the loan. Her income inflated, but her debt did not – even with the 5 percent interest.]
The U.S. Consumer Price Index for All Urban Consumers (CPI-U) did not change in June or July, after a small decrease in May, 2012, (seasonally adjusted.) That doesn't mean that prices did not change. Some prices went up and some prices went down. Most importantly for the determination of the July CPI-U data, energy prices went down. In July, the seasonally adjusted "core" CPI (all items less food and energy) increased just 0.1 percent (seasonally adjusted.
NOTE: Although this is information not included in August 15, 2012, BLS announcement, US gasoline prices increased significantly in late July and August 2012. This will be reflected in the BLS announcement next month.
July, 2012, is a good example of why it is not meaningful to think about the trend or "inflation" by looking at just one month's price data. Remember, inflation is a general price level rise over a period of time. If energy prices rise in August, 2012, the general price level may rise. Or, it may fall, depending on what happens with other prices.
Keep an eye on energy prices as a part of the more broad CPI-U over the coming months to determine if the CPI-U or the all items less food and energy (core) price level is the more meaningful for those who have to carefully plan their spending.
We tend to notice gasoline prices because they are posted in large numbers on street corners. We watch them move almost every day. We may not notice a price change for other items because we do not see them every day or purchase those items as often.
[Teacher Note: This may make an interesting class discussion. Students who drive and spend a much larger portion of their disposable income on gasoline may have a stronger response to higher gas prices.]
The CPI-U may not be a perfect measurement of the "cost of living" because it does not take into account individual differences, substitution or qualitative changes over time. It is, however, a standard measurement we have come to accept as we assess the health and dynamics of the economy.
Critics of the BLS measurement of the CPI argue that the current measurement process of the CPI-U has flaws that affect the meaning of the numbers and their impact on consumers. For instance, the CPU-U measures only urban consumer prices. They say that the CPI-U does not adequately account for changes in spending patterns over time, substitutions, and quality changes. Is the CPI-U, as currently measured, meaningful?
Is CPI an accurate assessment of the cost of living? An article in the August, 2008, "Monthly Labor Review," addresses "Common Misconceptions about the Consumer Price Index: Questions and Answers " The BLS web page has a summary of the article.
[Teacher Note: Students can read the summary and discuss whether or not the CPI is a meaningful measurement of cost of living. What are the "pros" and "cons"?]