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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.

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.

How the Annual Inflation Rate is Calculated
Month Price Level Monthly Inflation Rate Annual Inflation Rate
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?

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?

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.
    The market basket consists of three goods - tennis balls, movie ticket, 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