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Announcement

The seasonally adjusted rate of change in the consumer price index during the month of April 2002 was 0.5 percent (an increase of five-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 1.6 percent.

In April, the core consumer price index, which excludes energy and food prices, increased by 0.3 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.

Data Trends

In April, the Consumer Price Index rose by 0.5 percent, slightly higher than the 0.3 percent increase in March. This is largest seasonally adjusted monthly increase in the consumer price index since January 2001. In April, large increases in the prices indices of energy (4.5%), transportation (1.7%), and medical care (0.5%) caused the inflation rate to increase. The large increase in both the energy and transportation indices was due to rising gasoline prices in April. These increases were countered by decreases in the prices of education, communication, and apparel.

The core rate of inflation (0.3 percent in April) represents the consumer price index without the influences of changes in the prices of food and energy, which can fluctuate widely from month to month. The April increase compares to a 0.1 percent increase in the core rate of inflation for March and 0.3 percent during February.

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 at the beginning of 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 actually decreased. 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. 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. Other observers would describe the current experience as no or zero inflation.

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 April was 179.5. 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 April 2002 by 79.5 percent.

Inflation is usually reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in April was 179.5, compared to 178.6 in March. The increase in prices from March to April was (179.5-178.6) / 178.6 = 0.0050 or a monthly inflation rate of .50 percent. It is reported to the nearest one-tenth of a percent, in this case, 0.5 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.5)(12) = 6.0 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
April 179.5
179.5-178.6 = 0.0050
or 0.5%

178.6
1.005012 = 0.0622
or 6.2%
March 178.6

An exercise for understanding the meaning of inflation

The following question and answer appeared in a recent publication of a major financial firm.

"Have you experienced inflation recently? How was the inflation caused?

"Suggested answer: Recent increases in gas prices; prices of fruits and vegetables varying with seasons; bathing suits costing more in the spring and summer, movie ticket prices being less or more depending on the area…."

Can you evaluate the question and answer?

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, 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.

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.

Market Basket of Goods
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 April 24, in preparation for the FOMC meeting that was held on May 7, 2002.

"Almost all Federal Reserve Districts reported signs of improvement or actual increases in economic activity since the last survey. The sole exception was Boston, which described economic activity as mixed. While the overall tone was positive, a few districts expressed qualifications about the pace of the recovery or the strength of their regional economies. Cleveland said its economy continued to improve but cited concerns that the rate of improvement had slowed considerably from earlier in the year. Also, Kansas City and Dallas noted that their economies were still weak despite recent signs of improvement.

"Retail sales increased or held steady in most districts, and all districts reported stable or improved manufacturing conditions. Manufacturers' capital spending plans, however, remained limited. Residential real estate activity was strong in most districts, as both home sales and construction increased. Tourism activity also improved in most areas, while other services activity held steady. Demand for bank loans was little changed in most districts, although increases were reported in some regions. Commercial real estate markets remained generally weak. Energy activity continued to ease, and agricultural crops in several districts were damaged by adverse spring weather.

"Despite the increases in economic activity reported in many districts, labor markets remained slack and wage and price pressures generally stayed in check. Demand for labor showed signs of firming in several districts but was still reported as weak in others. Except for skilled health care workers, there were very few reports of labor shortages. Wage pressures, when mentioned, were characterized as minimal. Half of the manufacturers contacted in the Boston district expected to hold wages steady at least until the second half of the year. San Francisco reported that wages were being held back due to significant increases in health care and other insurance premiums. New York, Cleveland, Atlanta, and Dallas also reported substantial increases in insurance costs.

"Price pressures for consumer goods were generally subdued, and prices for most manufactured goods held steady despite higher costs for steel, fuel, and insurance. Retail prices were essentially flat in the New York, Kansas City, and San Francisco districts and were flat to down slightly in the Boston district. Retail price pressures in the Chicago district also remained subdued, with price-conscious consumers discouraging retailers from going ahead with planned increases. Steel producers in the Cleveland and Chicago districts raised prices significantly. Despite reports of increasing input costs in some districts, other manufacturers generally held their selling prices constant. Concerns about rising input costs were especially pronounced in the Dallas district, where rising costs for fuel, petroleum-based products, and insurance were said to be adversely affecting many industries."

The Beige Book report can be found at:
www.federalreserve.gov/fomc/BeigeBook/2002/20020424/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 meetings on January 29/30 and on March 19, 2002, the Federal Reserve decided to leave the target federal funds rate unchanged. Below is an excerpt from the press announcement following the March 19, 2002 meeting.

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

"The information that has become available since the last meeting of the Committee indicates that the economy, bolstered by a marked swing in inventory investment, is expanding at a significant pace. Nonetheless, the degree of the strengthening in final demand over coming quarters, an essential element in sustained economic expansion, is still uncertain.

"In these circumstances, although the stance of monetary policy is currently accommodative, the Committee believes that, for the foreseeable future, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals."

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?
  2. What are the relevant economic concepts?
  3. What are the policy options for the Federal Reserve?
  4. Analyze current conditions with regard to policy options.
  5. Based on the analysis and the goals, choose the correct economic policy.

An Exercise

There have been many news reports lately about the rising costs of college tuition. In 2000, the average cost of tuition at four-year private colleges was $16,233 compared to $17,123 in 2001. At four-year public institutions, the average tuition increased from $3,487 to $3,754. What was the rate of increase in tuition for public and private colleges? Did the real cost of tuition increase?

Other Questions for Students

  1. Suppose the CPI was 160 for June 1999, and was 180 for June 2000. What is the corresponding annual rate 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?
  3. If prices increase by five percent in a year, what effect does this have on the purchasing power of individuals in the economy?
  4. What are the costs of increased rates of inflation?
  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 2000Quantity Sold Price Quantity sold Price
    The market basket consists of three goods - tennis balls, movie ticket, and fast-food restaurant meals.
    Tennis balls 1000

    $1.00

    1500

    $ .90

    Movie tickets 500

    8.00

    600

    9.00

    Fast-food meals 400 5.00 500 6.00