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The seasonally adjusted rate of change in the consumer price index during the month of January 2002 was 0.2 percent or an increase of two-tenths of one percent. The rate of increase in the consumer price index over the past twelve months was 1.1 percent. In January, the core consumer price index, which excludes energy and food prices, also increased by 0.2 percent.

KEY CONCEPTS

Consumer Economics, Consumer Price Index (CPI), Consumers, Deflation, Full Employment, Inflation, Monetary Policy, Money, 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...

MATERIALS


Announcement

The seasonally adjusted rate of change in the consumer price index during the month of January 2002 was 0.2 percent or an increase of two-tenths of one percent. The rate of increase in the consumer price index over the past twelve months was 1.1 percent.

In January, the core consumer price index, which excludes energy and food prices, also increased by 0.2 percent.

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.

Note to the Teacher

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

Data Trends

The Consumer Price Index rose slightly during January after declining 0.2 percent in December. In January, prices of food, housing, transportation, medical care and education and communication all increased. Large increases in gasoline prices contributed to the increase in the price level but these increases were countered by decreases in the prices of other energy and apparel. The core rate of inflation represents the consumer price index without the influences of changes in the price indices for food and energy, which can fluctuate widely from month to month. The core rate of inflation increased to 0.2 percent for the month of January, an increase from 0.1 percent in December.

Figure 1 below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to1998, slowed throughout much of 2000, and then increased slightly in 2001. If inflation is considered over the eight quarters of 2000 and 2001, the annual rates of change were 6.1, 2.6, 2.8, 2.1, 4.0, 3.7, 0.7 and -2.0 percent. The rate of inflation increased in January through May of 2001. Inflation has been decreasing since that point. During the fourth quarter, the price index was actually decreasing. What is really quite obvious from figure 1 is that the changes in inflation from month to month are much more dramatic from 1999 on, when compared to 1998. The increased volatility is primarily due to fluctuations in the prices of oil and food. The core rate of inflation (excluding food and energy) gives a much better idea of longer-term trends and that is why it is often featured in news reports. In January, the rate of inflation is the same as the core rate of inflation. See figure 2.

Figure 1: Monthly Inflation in Consumer Prices at Annual Rates

Figure 2: Monthly Core Inflation Rate (excludes food and energy)

Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is quite low. See figure 3 below. Few observers would describe the most recent rates as high and they are not, when compared to those of the past thirty years. .

Figure 3: Inflation in Consumer Prices since 1970

Definitions of Inflation and the Consumer Price Index

Inflation is a sustained increase in the overall level of prices. The most widely reported measurement of inflation is the consumer price index (CPI). The CPI measures the cost of a fixed basket of goods relative to the cost of that same basket of goods in a base (or previous) year. Changes in the price of this basket of goods approximate changes in the overall level of prices paid by consumers.

The seasonally adjusted consumer price index in January was 177.6. The price index was equal to 100 during the period from 1982 to 1984. The interpretation is that prices in market basket of goods purchased by the typical consumer increased from the 1982-1984 period to January 2002 by 77.6 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 January was 177.6, compared to 177.3 in December. The increase in prices from December to January was (177.6-177.3) / 177.3 = 0.0017 or a monthly inflation rate of 0.17 percent. It is reported to the nearest one-tenth of a percent, in this case, 0.2 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.2)(12) = 2.4 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 12th power.

Month Price Level Monthly Inflation Rate Annual Inflation Rate
How the Annual Inflation Rate is Calculated
January 177.6
177.6-177.3 = 0.0017
or 0.2 %

177.3
1.001712 = 0.0205
or 2.0%
December 177.3

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 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 makes the 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 is higher. 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.

Causes of Inflation

Over short periods of time, inflation can be caused by a decrease in production or an increase 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 there are high levels of unemployment, then there is less, or at least a slower growth in, spending in the economy and the inflation is subdued. If there is low unemployment, then wages are increasing to attract workers to jobs and this creates upward pressure on prices, that is, 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. Thus 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. 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.

Deflation

If average prices were to fall over a significant period, economists would describe the economy as experiencing deflation. But a single month decrease in prices would not be described as such, just as a single increase in prices is not described accurately as inflation. Deflation can be caused by a decrease in spending in the economy, which also means that real GDP would be falling. That type of deflation can occur in a relatively serious recession.

It is also possible for prices to fall as a result of falling input prices or widespread increases in productivity. In this case, the economy would be experiencing an increase in real GDP, an outcome certainly to be preferred over the recessionary deflation.

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 percentages that are currently used to describe the categories of goods and services that market basket are as follows.

Food and beverages   16 %    Recreation   6 %
Housing   41 %   Education   3 %
Clothing   4 %   Communication   3 %
Transportation   17 %   Other goods and services   4 %
Medical care   6 %        

The Future of Inflation

The Federal Reserve's report on economic conditions across the country is released in the "Beige Book" (named for its beige cover) two weeks prior to each meeting of the Federal Reserve Open Market Committee. The following is an excerpt from the Beige Book released on January 16, 2002, in preparation for the FOMC meeting on January 29/30, 2002.

"Reports from the Federal Reserve Districts suggest that economic activity generally remained weak from late November through early January. But while there are still indications of caution, there are also scattered reports of improvement. The Dallas and San Francisco Districts report a continued decline in activity, while the Cleveland District indicates that the regional economy appears to be in the process of bottoming out. Economic activity remained slow or weak in the Boston, Chicago, Philadelphia, Kansas City and St. Louis Districts. Activity was mixed according to the Atlanta, Minneapolis and Richmond Districts and showed further signs of rebounding in the New York District.

"Many Districts indicate that their contacts believe a recovery will begin by mid-year or earlier, but the timing and strength are uncertain. Several Districts say that uncertainty has led some businesses to budget conservatively for the first quarter. Manufacturing activity was weak or down in most reports, but showed signs of stabilizing or rebounding in several Districts. Retail sales picked up in late December and early January but for the period overall posted generally weak results in most Districts.

"Labor markets remain soft, according to most District reports. Further layoffs are expected in the Boston District, but the Chicago and New York Districts say labor markets are stabilizing. While there were reports of shrinking pay increases in the Chicago District, some firms are freezing pay scales in the Boston District, and downward wage pressures are reported in the Cleveland, Kansas City and San Francisco Districts.

"Districts report declining prices for most goods and services with the notable exception of security, health care and medical, property and liability insurance. The Atlanta, Boston, Dallas, Minneapolis and New York Districts report steep increases in insurance costs.

"Energy costs are lower and, as the Cleveland District notes, firms have reduced or eliminated energy surcharges. According to the Dallas District, warm weather and flagging demand led to declines in natural gas, crude oil and refined product prices. Forecasts of colder weather and collaboration between OPEC and non-OPEC producers to restrict crude oil production led prices to bounce back to just below mid-November levels. Inventories of most energy products, however, are significantly higher than a year ago."

The Beige Book report can be found at:
www.federalreserve.gov/fomc/BeigeBook/2002/20020116/default.htm

Between January and December 2001, the Federal Reserve's Open Market Committee decided to lower the target federal funds rate eleven times, for a total decrease of 4.75% in the target federal funds rate. The discount rate was also lowered. At the most recent meeting, on January 29 and 30, 2002, the Federal Reserve decided to leave the target federal funds rate unchanged. Below is an excerpt from their announcement.

"The Federal Open Market Committee decided today to keep its target for the federal funds rate unchanged at 1-3/4 percent.

"Signs that weakness in demand is abating and economic activity is beginning to firm have become more prevalent. With the forces restraining the economy starting to diminish, and with the long-term prospects for productivity growth remaining favorable and monetary policy accommodative, the outlook for economic recovery has become more promising.

"The degree of any strength in business capital and household spending, however, is still uncertain. Hence, the Committee continues to believe that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future."

The original press release is available at:
www.federalreserve.gov/boarddocs/press/general/2002/20020130/default.htm

Case Study

  1. What are the key parts of the consumer price index and the Federal Reserve announcements?

    [Both the general price index and the core index increased by 0.2 percent in January, a modest increase over the decline in overall prices during December. The relative absence of price pressures this month is reflected in stable retail prices in many parts of the country. Over the last quarter of 2001, the decrease in the demand for labor, a decline in both investment spending and production, and the softening in business and household demand all contributed to an environment without significant inflationary pressures. As the economy strengthened in January, increases in spending resulted in small increased pressures on prices.

    The Federal Reserve is still concerned about the strength of the economy and states, "the risks are weighted mainly toward conditions that may generate economic weakness." Apparently, the Federal Reserve is not very concerned with inflationary pressures in the near future.]

  2. What are the relevant economic concepts?

    [Falling spending, the labor force, the full-employment level of real GDP, and inflation.]

  3. What are the policy options for the Federal Reserve?

    [The Federal Reserve can increase or decrease the target federal funds rate or leave the target federal funds rate at its current level.]

  4. Analyze current conditions with regard to policy options.

    [As unemployment rose during 2001, upward pressures on wages were abating. However, as the labor markets begin to stabilize, the upward pressures on wages may become more important. However, the good news on the inflation front is the slowing growth in spending. There seems to be very little inflationary pressure.

    In spite of slow productivity growth, the Federal Reserve expects the longer-run upward trend in productivity to continue. Growing productivity allows for increased wages without increasing upward pressure on prices of goods. This will reduce future inflationary pressures. (See the Productivity case study).

    Decreasing the target federal funds rate will likely lead to increases in investment spending and consumption spending, thereby increasing total spending in the economy. A decrease in interest rates decreases the cost of borrowing money for investment purposes. Investment spending increases as a result. The decrease in interest rates also decreases the costs of consumer borrowing to purchase automobiles and houses. With lower interest rates, spending in those markets is also likely to increase.

    The increases in investment and consumption spending result in a higher level of real GDP, and a lower level of unemployment as businesses hire workers in order to accommodate higher levels of spending. However, one side effect is that the increased spending may contribute to upward pressures on prices. Given current conditions, this slightly increased upward pressure is likely to be minor. The Federal Reserve is obviously more concerned with the potential slowing in the economy.]

  5. Based on the analysis and the goals, choose the correct economic policy.

    [Over the past year, the U.S. economy has undergone major changes. The US entered a recession in March 2001, which was accompanied by rising unemployment and slowing growth of GDP and productivity. (See the GDP Case Study.) The Federal Reserve responded to economic slowdown by lowering the target federal funds rate by 4.75%. Evidence that monetary policy is beginning to impact the economy is seen in the January 2002 Beige Book which indicates that labor markets are stabilizing, manufacturing is starting to rebound, and prices remain stable throughout most of the country.

    Many forecasters are suggesting that the economy will continue to strengthen and that a recovery will be apparent in mid-2002. However, if the Federal Reserve Open Market Committee continues to be concerned with a slowdown in the rate of growth in spending, the target federal funds rate could be further lowered at future meetings or between meetings.]

Other Questions for Students

You may use these questions for discussion your class or use this reproducible.

  1. Suppose the CPI was 160 for June 1999, and was 180 for June 2000. What is the corresponding annual rate of inflation?

    [The rate of increase in prices from June 1999 to June 2000 can be calculated by dividing the increase in the index by the initial level of the index. (These indexes show a much higher rate of inflation than the actual.)

    That is (180 - 160) / 160 = .125 or 12.5 percent. Because this is over a twelve-month period, it is an annual rate of inflation. More difficult interpretations are based on single-month changes. The results are normally converted to annual rates of inflation.]

  2. The base year of the CPI is 1982-1984. What has happened to prices since 1970 if the 1970 index was approximately 40 and if the current CPI were 160?

    [A current level of 160 would mean that consumer prices on average are 300 percent higher than their 1970 levels. The percentage increase is (160 - 40) / 40 = 3 or 300 percent. The base year period is not relevant to the calculation.]

  3. If prices increase by five percent in a year, what effect does this have on the purchasing power of individuals in the economy?

    [Students may answer that purchasing power goes down since their money is worth less, and consequently they cannot buy as many goods and services. The value of money does fall. However, they are ignoring the point that inflation affects wages as well. If average incomes and prices of goods and services have increased by five percent, the purchasing power of average income remains unchanged.]

  4. What are the costs of increased rates of inflation?

    [Large increases in the price level make it difficult for businesses to estimate future levels of revenues and costs of products. This may discourage some businesses from expanding and making investment decisions. In addition, real income may be redistributed as some incomes rise parallel to or faster than rates of inflation and others are slower to rise. Higher inflation rates lead to higher interest rates. As a result, more resources will be devoted to managing financial assets. Those resources could be used in times of lower inflation to produce other goods and services.]

  5. Calculate a consumer price index based on the following data. Calculate the indexes for the two years and determine the annual rate of inflation.

    The market basket consists of three goods: tennis balls, movie tickets, and fast-food restaurant meals.

     

    1999

     

    2000

     
     

    Quantity sold

    Price

    Quantity sold

    Price

    Tennis balls

    1000

    $1.00

    1500

    $ .90

    Movie tickets

    500

    8.00

    600

    9.00

    Fast-food meals

    400

    5.00

    500

    6.00

    [Price indexes are calculated by determining the cost of a fixed basket of goods. If we were to use the data in question five to calculate an index similar to the consumer price index, we would begin with the market basket. That market basket might be the consumption patterns of 1999. The cost of that market basket is the sum of the 1999 quantities times the 1999 prices. (1000 x $1.00) + (500 x $8.00) + (400 x $5.00) = $7,000. The cost of that SAME market basket in 2000 prices is (1000 x $.90) + (500 x $9.00) + (400 x $6.00) = $7,800. (Students are likely to have problems thinking about which market basket to use and which prices to use.)

    The 1999 base year index is the cost of the 1999 basket in 1999 prices divided by the cost of the base year (1999) basket. Or $7,000/$7,000 = 1. However, it is normally stated as 100. (Simply multiply the result by 100.)

    The 2000 year index is the cost of the 1999 basket in year 2000 divided by the cost of the base year (1999) basket in 1999. Or $7,800/$7,000 = 1.11. However, it is normally stated as 111. (Multiply the result by 100.)

    The rate of inflation is found by determining the percentage increase in the consumer price index between the two years. In this case, it is easy to see. The annual rate of inflation was 11 percent. {(111-100)/100 = .11 (or 11 percent)}]