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The seasonally adjusted rate of change in the consumer price index during the month of August 2002 was 0.3 percent (an increase of three-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 1.8 percent. In August, the core consumer price index, which excludes energy and food prices, also increased by 0.3 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 August 2002 was 0.3 percent (an increase of three-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 1.8 percent.

In August, the core consumer price index, which excludes energy and food prices, also 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.

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.

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 August was 180.5. 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 August 2002 by 80.5 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 August was 180.5, compared to 179.9 in July. The increase in prices from July to August was (180.5-179.9) / 179.9 = 0.0033 or a monthly inflation rate of .33 percent. It is reported to the nearest one-tenth of a percent, in this case, 0.3 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (0.3)(12) = 3.6 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
August 180.5
180.5-179.9 = 0.0033
or 0.3%

179.9
1.003312 = 0.0403
or 4.0%
July 179.9

Data Trends

In August, the Consumer Price Index rose by 0.3 percent, higher than the 0.1percent increase in July. This is largest seasonally adjusted monthly increase in the consumer price index since April 2002. In August, large increases in the price indices for apparel (1.1%), education (0.7%), and energy (0.6%) caused the inflation rate to increase.. The large increase in the energy index was due to rising gasoline prices in August, advancing for the second consecutive month. This increase was partially countered by a decrease in the price of food and beverages (-0.1%).

The core rate of inflation (0.3 percent in August) 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 August increase compares to a 0.2 percent increase in the core rate of inflation for July and 0.1 percent during June.

Figure 1 below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to1998. Inflation seems to be lower in 2001, as prices even fell in some months. 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.

Figure 1: Monthly Inflation in Consumer Prices at Annual Rates

It is easier to get an idea of trends if we look at inflation rates over entire year. Those results are shown in table two. Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is quite low. Few observers would describe the most recent rates as high and they are not, when compared to those of the past thirty years. Inflation is quite low. Some analysts would even describe the current experience as no or zero inflation.

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

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?

[A better analysis focuses on the definition of inflation. Inflation is a sustained increase in the overall level of prices. In a market economy, prices vary in different seasons and in different areas. There are always some prices increasing and others decreasing as demand and supply conditions change in the markets. Inflation is an increase in average or overall price levels. It is not increases in specific markets or differences in prices in seasons or areas as described in the above 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 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.

Causes of Inflation

Over short periods of time, inflation can be caused by increases in costs 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, when caused by changes in demand, has an inverse relationship with unemployment. If spending is rising more slowly than capacity to produce, unemployment will be rising and there will be little demand-pull inflation. If spending is rising faster than capacity, unemployment is likely to be falling and demand-pull inflation increasing.

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 %        

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?

[One way to approach the exercise is to compare rates of increase in tuition with the rate of inflation. In essence, is tuition increasing at the same rate as inflation, at a faster rate, or at a slower rate?

The consumer price indexes for 2000 and 2001 were 172.2 and 177.1. To calculate the rate of inflation, find the increase and divide it by the 2000 index. (177.1-172.2)/172.2 = 2.8 percent. The increase in private college tuition was $890, or an increase of 5.5% ($890/$16,233). This exceeds the rate of inflation. The increase in public college tuition was $267, or an increase of 7.7% ($267/$3,487). This also exceeds the rate of inflation.

An alternative method that is often used to compare incomes, levels of output, and prices is to change the 2001 figure into terms of 2000 dollars. Thus we would create a new index showing the increase in prices. (177.1/172.2 = 1.028) To report the new number as an index, we normally multiply it by 100. However to express the 2001 figure in 2000 dollars, we divide the 2001data by the new index. (Thus for the public tuition, $3,754/1.028 = $3,652. Given that the 2001 tuition (in terms of 2000 dollars) is larger than the 2000 tuition (in terms of 2000 dollars), we would describe the change as an increase in the real cost of going to college.]

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?

    [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 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?

    [Students will likely answer that it lowers real incomes. But in most inflationary periods, nominal incomes increase at least as rapidly as prices. 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.

    [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)]

    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 6.0

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