The consumer price index (CPI) during the month of May decreased by .1 percent (one-half of one percent). The rate of increase in the consumer price index over the past twelve months has been 2.8 percent.

In May, the core consumer price index, which excludes energy and food prices, increased by .1 from April. The core index has increased by 2.2 percent over the last twelve months.

Please do the following multiple choice activity:




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 continual increase in the overall level of prices. It is an increase in average prices that lasts at least a few months. The most widely reported measurement of inflation is the consumer price index (CPI). The CPI measures the cost of a set of goods and services relative to the cost of those same goods and services in a previous month or year. Changes in the prices of those goods and services approximate changes in the overall level of prices paid by consumers.

The core consumer price index is the cost of the same set of goods and services without including food and energy relative to the cost of the set without food and energy in a previous month or year.

Data Trends

In May, the consumer price index decreased by .1 percent, after increasing .6 percent in April and by .6 percent in March. In May, energy prices decreased rapidly for the after increasing for three months in a row. Price indexes for transportation also fell. The largest increases were for medical care and recreation.

The .1 percent decrease reverses a series of relatively large increases in the CPI. The annual rate of increase over the last three months was 4.6 percent and over the last 12 months, 2.9 percent. Annual inflation rates during all of 2002, 2003, and 2004 were 1.6, 2.3 and 2.7 percent.

While a number of news stories will focus on the decrease in the consumer price index, we should be cautious about placing too much emphasis on any one month change. In December of 2004 the CPI fell by .1 percent, but since that point has increased at a faster rate than the last three years.

The core rate of inflation (increased by .2 percent in May) 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 increased May index compares to a .7 percent increase in the core rate of inflation in April and .2 percent in March Core prices increased more slowly in those months than the overall index due to the rapid rises in prices of energy.

Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices. This month's results provide some evidence that the increase in energy prices has not significantly influenced rates of increases in all other prices.

Figure 1 shows recent inflation data reported for each month. It is obvious that the monthly inflation figures change a great deal from one month to the next. However, the trend has been an increasing trend over the last five months. It is however difficult to tell what the trend over a longer period of time has been.

Figure 2 shows annual rates of inflation from the 1970s to now. Compared to the rates of inflation in the 1970s and much of the 1980s, the current rate of inflation is low. Few observers would describe the most recent rates as high and they are not, when compared to those of the past thirty years. However, the recent rates have been increasing and that has caused some concern. See the most recent Federal Reserve case study and the exercises at the end of this case.


The Consumer Price Index

The seasonally adjusted consumer price index in May was 194.1. The price index was equal to 100 during the period from 1982 to 1984. The appropriate interpretation of the index is that prices in the market basket of goods and services purchased by the typical consumer increased from the 1982-1984 period to May 2005 by 94.1 percent. A typical consumer good that cost one dollar in 1983 now costs $1.94.

Inflation is announced and usually reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in May was 194.1, compared to 194.2 in April. The decrease in prices from April to May was (194.1 – 194.2) / 194.2 = - 0.0005, normally rounded to -.001. That means a monthly inflation rate of a negative one-tenth of a percent. Or deflation of one-tenth of a percent.

To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (-.1) (12) = - 1.2 percent.

Table 1
Month Price Level Monthly Inflation Rate
May 194.1
194.1 - 194.2 = - .0005 or -.1%

April 194.2

How the CPI is Calculated

Assume that there are only two goods included in the typical consumer's purchases and, in the base or the original year, each of the goods has a price of $10.00. Each consumer purchases one unit of each good.

In the current year, the goods' prices are $11 and $12. The index for the current year would be the quantities purchased in the market basket in the base year (one each of each good) times their prices in the current year divided by the quantities purchased in the market basket in the base year times their prices in the base year.

Thus ( 1 x $11 + 1 x $12 ) / ( 1 x $10 + 1 x $10 ) = $23 / $20 = 1.15. That is, prices in the current year are 1.15 times the prices in the original year. Prices have increased on average by 15 percent. That is true. The price of the first good increased by 10 percent. The price of the second good increased by 20 percent. By convention, the indexes are multiplied by 100 and reported as 115 instead of 1.15.

The base year index simply divides the prices in the base year (times the quantities in the base year) by the prices in base year (times the quantities in the base year). The base-year index then is 1.00; or multiplied by 100 equals 100.

How the CPI Data are Collected

The Bureau of Labor Statistics samples the purchases of households representing 87 percent of the population. 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. Forty-one percent of the market basket is made up of goods that consumers purchase. The other fifty-nine percent includes services.

Goods and services sampled include food, clothing, housing, gasoline, other transportation prices, medical, dental, and legal services and hundreds of other retail goods and services. Taxes associated with the purchases are included. Each item is weighted in the average according to its share of the spending of the households included in the sample. Almost 100 urban areas are sampled by Bureau of Labor Statistics professionals. Visits and phone calls are made to 50,000 households and almost 25,000 retail stores and offices.

For more information on the Bureau of Labor Statistics, visit [EEL-link id='1222' title='' ] .

CPI Interactive Exercise

Suppose a sandwich at the local fast food restaurant costs $5. If the price index is 194.1 now, approximately how much did that sandwich cost in 1983 (the base year) if sandwich prices changed at the same rate as all other prices?

Please do the following multiple choice activity:

Causes of Inflation

Please do the following multiple choice activity:

Over short periods of time, inflation can be caused by increases in costs or increases 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 faster than capacity to produce, unemployment is likely to be falling and demand-pull inflation increasing. If spending is rising more slowly than capacity to produce, unemployment will be rising and there will be little demand-pull 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. 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 facing consumers. 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 Note on Seasonally Adjusted and Unadjusted Data

"Because price data are used for different purposes by different groups, the Bureau of Labor Statistics publishes seasonally adjusted as well as unadjusted changes each month. For analyzing general price trends in the economy, seasonally adjusted changes are usually preferred since they eliminate the effect of changes that normally occur at the same time and in about the same magnitude every year--such as price movements resulting from changing climatic conditions, production cycles, model changeovers, holidays, and sales.

The unadjusted data are of primary interest to consumers concerned about the prices they actually pay. Unadjusted data also are used extensively for escalation purposes. Many collective bargaining contract agreements and pension plans, for example, tie compensation changes to the Consumer Price Index unadjusted for seasonal variation." ([EEL-link id='1271' title='' ] )

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 relative importance of each of the categories of goods and services that included in the market basket are as follows.

Housing 42 %   Recreation 6 %
Transportation 17 %   Education and communication 6 %
Food and beverages 15 %   Clothing 4 %
Medical care 6 %   Other goods and services 4 %

Policy Question

What should the Federal Reserve do with its monetary policy given this month's consumer price index announcement? Explain why.

Other questions

  1. If inflation is 2 percent a year and average income increases by 4 percent, what has happened to real average income ?
    1. Decreased by 2 percent
    2. Decreased by 4 percent
    3. Increased by 2 percent
    4. Increased by 4 percent
    5. Increased by 6 percent
  2. If GDP increases by 6 percent over a year and the GDP price index increases by 2 percent, what has happened to real GDP?
    1. Increased by 2 percent
    2. Increased by 4 percent
    3. increased by 6 percent
    4. Increased by 8 percent
  3. Suppose the CPI was 200 for May of one year, and was 210 for May of the next year. What is the approximate annual rate of inflation for those 12 months?
    1. percent
    2. 10 percent
    3. 20 percent
    4. 21 percent
    5. 110 percent
  4. Suppose a bicycle cost $50 in 1983 and a similar new bicycle costs $125? Given what you know about price indexes, has the real cost of the bicycle increased or decreased?
    1. increased
    2. decreased
    3. stayed the same
    4. one cannot tell.
  5. The consumer price index has increased from 100 to 110 and average incomes have gone from $30,000 to $33,000, what has happened to real income?
    1. increased
    2. decreased
    3. not changed
    4. one cannot tell.