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Announcement

The seasonally adjusted rate of change in the consumer price index (CPI) during the month of June 2003 was 0.2 percent (an increase of two-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 2.1 percent.

In June, the core consumer price index, which excludes energy and food prices, was constant.

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.

Data Trends

In June, the Consumer Price Index increased by 0.2 percent. In April, the CPI dropped by .3 percent and did not change in May. In June, increases in the prices of energy and food were largely responsible for the increased rate of inflation.

The core rate of inflation (0.0 percent in June) 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 June level compares to a 0.3 percent increase in the core rate of inflation for May.

Figure 1 below shows recent inflation data reported for each month. Inflation increased in 1999 and 2000 when compared to1998, slowed throughout much of 2001, and then increased slightly in 2002 and 2003. 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.

Deflation

Current news articles have referred to concerns about possible deflation. Prices have fallen over brief periods, as they did most recently in April (and three months in 2001).

Deflation, however, is defined as a sustained decrease in the overall level of prices, that is, a continual fall in prices. That may sound like a good event, but we have to remember that it also is likely to mean that wages and incomes fall also.

In fact, the reason that deflation may be of concern (if it were to happen) is that consumers and businesses might reduce current spending in expectation of lower prices in the near future. The resulting decrease in spending may cause a subsequent fall in prices. The falling prices leading to expectations of falling prices leading to decreased spending could create a spiral downward into recessionary conditions.

The Consumer Price Index

The seasonally adjusted consumer price index in June was 183.6. 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 June 2002 by 83.6 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 June was 183.6, compared to 183.3 in May. The increase in prices from May to June was (183.6-183.3) / 183.3 = 0.0016 or a monthly inflation rate of .0.16 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 (0.1)(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.

How the Annual Inflation Rate is Calculated
Month Price Level Monthly Inflation Rate Annual Inflation Rate
November 183.6
183.6-183.3 = 0.0016
or 0.16%

183.3
1.001612 = 1.01937
or 1.9%
October 183.3

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.

  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, in the short run and 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 %        

Using the CPI as an Inflation Index

The Social Security Administration announced on October 18 that Social Security payments, beginning in January 2003, will increase by 1.4 percent. Annual changes in Social Security payments are based on changes in the consumer price index. The rate of change in consumer prices from October of one year through September of the next is used to calculate the appropriate change in the Social Security payments for the following year. The purpose of the adjustment is to maintain the real purchasing power of the Social Security payments, that is, to reduce the cost of inflation for those who might otherwise be living on fixed incomes.

Income tax brackets and deductions also change according to changes in the consumer price index. Private contracts often also reference changes in inflation as measured by the consumer price index.

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. What is inflation?
  2. Calculate a consumer price index in 2001 for the following market basket of goods (using 2001 as a base year).

    2001
    3 boxes of cheerios   $4.00 each
    2 pounds of bananas   $1.00 per pound
    2 gallons of milk   $3.00 per gallon
    2002
    4 boxes of cheerios   $5.00 each
    1 pounds of bananas   $2.00 per pound
    2 gallons of milk   $3.00 per gallon

  3. Calculate a consumer price index in 2002 (using 2001 as a base year).
  4. Given this market basket, what is the annual rate of inflation from 2001 to 2002?