The seasonally adjusted rate of change in the consumer price index (CPI) during the month of August 2003 was 0.3 percent (an increase of four-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 2.2 percent. In August, the core consumer price index, which excludes energy and food prices, increased 0.1 percent. Over the last twelve months, the core index increased 1.3 percent.
Current Key Economic Indicatorsas of November 30, -0001
The seasonally adjusted rate of change in the consumer price index (CPI) during the month of August 2003 was 0.3 percent (an increase of four-tenths of one percent). The rate of increase in the consumer price index over the past twelve months was 2.2 percent.
In August, the core consumer price index, which excludes energy and food prices, increased 0.1 percent. Over the last twelve months, the core index increased 1.3 percent.
[Note to teacher: All paragraphs in italics will not appear in the student version of the inflation case study. This case builds upon the previous inflation case study. More advanced concepts and questions will be added throughout the fall semester.
The original press release can be found at www.bls.gov/news.release/cpi.nr0.htm .
This lesson uses several charts and tables. You may use these files to create student reproducables or overhead transparencies for use in your classroom.
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.
Definitions of Inflation
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.
[Brief Explanation of the CPI
"The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and services purchased by households. The CPI is based on prices of food, clothing, shelter, and fuels, transportation, fares, charges for doctors' and dentists' services, drugs, and other goods and services that people buy for day-to-day living.
Prices are collected in 87 urban areas across the country from about 50,000 housing units and approximately 23,000 retail establishments - department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments. All taxes directly associated with the purchase and use of items are included in the index. Prices of fuels and a few other items are obtained every month in all 87 locations.
Prices of most other commodities and services are collected every month in the three largest geographic areas and every other month in other areas. Prices of most goods and services are obtained by personal visits or telephone calls of the Bureau's trained representatives. For more information on the Bureau of Labor Statistics, visit (www.bls.gov )."]
In August, the Consumer Price Index increased by 0.3 percent. The CPI increased by 0.2 percent in June and again by the same amount in July. In August, increases in the prices of energy and transportation were largely responsible for the increased rate of inflation. Food prices also increased during the month.
The core rate of inflation (an increase of 0.1 percent in the core CPI 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 level compares to a 0.2 percent increase in the core rate of inflation for July and a steady index in June.
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.
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. Inflation is not a current problem or a major concern.
The seasonally adjusted consumer price index in August was 184.5. 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 2003 by 84.5 percent.
Changes in the CPI are usually reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in August was 184.5, compared to 183.9 in July. The increase in prices from July to August was (184.5-183.9) / 183.9 = 0.0033 or a monthly inflation rate of .0.33 percent. It is reported to the nearest one-tenth of a percent, in this case, 0.3 percent.
However, inflation rates are normally discussed as annual rates of change in price levels. To convert the monthly change into an annual rate, you could simply multiply the monthly rate 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.
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.
|1.003312 = 1.0398
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.]
An interesting exercise is to ask students to take a sample of prices at several stores and calculate a price index. Do the same one month later and calculate a new index and a monthly and annual rate of inflation. A hypothetical interactive exercise is at the end of this case study.
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.
- 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.
- 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.
- 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.
- Inflation does reduce the purchasing power of money.
- 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.
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 %|
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
- What is inflation? [A continual increase in the average price level.]
- 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
- Calculate a consumer price index in 2002 (using 2001 as a base year). 
- Given this market basket, what is the annual rate of inflation from 2001 to 2002? [25 percent]
[Note to teacher:
- The important points are that most prices or average prices rise and that the increase continues and is not just a one-time increase.
- For the base year, the price index is calculated by first taking the 2001 quantities times the 2001 prices. As it is the base year, that number is divided by itself and multiplied by 100.
- The price index is calculated by first taking the 2001 quantities times the 2001 prices. The 2002 prices are then multiplied by the 2001 quantities. Then the latter (the amount spent if only the prices change) is divided by the 2001 prices times 2001 quantities and multiplied by 100. ($25/$20) x 100 = 125. The most common mistake will be to calculate the second year with the 2002 prices and 2002 quantities.
- The 2001 index is subtracted from the 2002 index and the difference is divided by the 2001 index. (125-100)/100 = .25 or 25 percent. An easier way, given that the first year is the base year of 100 is simply to compare the two directly. An index of 125 means that prices have gone up by 25 percent since the base year.]
Other Questions for Students
- Suppose the CPI was 150 for July of one year, and was 170 for July of the next year. What is the corresponding annual rate of inflation?
[The rate of increase in prices from over the year 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 (170 - 150) / 150 = .133 or 13.3 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.]
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.]
- 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.]
- 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.]