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Announcement

The consumer price index (CPI) during the month of September increased by 1.2 percent. The rate of increase in the consumer price index over the past twelve months has been 4.7 percent.

In September, the core consumer price index, which excludes energy and food prices, increased by .1 percent (one-tenth of one percent). The core index has increased by 2.0 percent over the last twelve months.

Please do the following multiple choice activity:

Figure 1: Monthly Rate of 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 compares the prices of a set of goods and services relative to the prices 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 average price of the same set of goods and services, without including food and energy prices, relative to the price of the set without food and energy prices in a previous month or year.

Data Trends

In September, the consumer price index increased by 1.2 percent, after increasing .5 percent in each of the previous two months. In September, energy prices increased rapidly for the month in a row. Price indexes for transportation also rose.

The annual rate of increase over the last three months was 9.4 percent and over the last 12 months, 4.7 percent. Annual inflation rates during all of 2002, 2003, and 2004 were 2.4, 1.9 and 3.3 percent.

While a number of news stories will focus on the rather rapid increase in the consumer price index, we should be cautious about placing too much emphasis on any one month change.

The core rate of inflation (increased by .1 percent in September) represents changes in 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 September index compares to a .1 percent increase in the core rate of inflation in each of the previous five months. Core prices increased more slowly in the last three months than the overall index due to the rapid rises in prices of energy. The annual rate of increase in prices of energy over the last three months was 122 percent.

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. Still the rapid rise in energy prices may eventually have a significant effect on all other prices in the economy.

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, prior to this month, 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.

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

The Consumer Price Index

The seasonally adjusted consumer price index in September was 198.8. 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 September 2005 by 98.8 percent. A typical consumer good that cost one dollar in 1983 now costs almost $2.00.

Inflation is announced and reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the CPI in September was 198.8, compared to 196.4 in August. The increase in prices from August to September was (198.8 - 196.4) / 196.4 = + 0.012. That means a monthly inflation rate of 1.2 percent.

To convert this into an approximate annual rate, you can simply multiply by 12. This provides us an annual inflation rate of (1.2) (12) = 14.4 percent.

Table 1
Month Price Level Monthly Inflation Rate
May 198.8
198.8 - 196.4 = + .012 or + 1.2%

196.4
April 196.4

How the CPI is Calculated

Assume that there are only three goods (instead of goods and services in over 200 categories in the actual calculation) included in the typical consumer's purchases and, in the base or the original year, the goods had prices of $10.00, $20.00, and $30.00. The typical consumer purchased ten of each good.

In the current year, the goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good.

The CPI for the current year would be the quantities purchased in the market basket in the base year (ten 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 [ (10 x $11) + (10 x $24) + (10 x $33)] / [( 10 x $10) + (10 x $20) + (10 x $30)] = $680 / $600 = 1.133. That is, prices in the current year are 1.133 times the prices in the original year. Prices have increased on average by 13.3 percent. The quantities are the base year quantities in both the numerator and the denominator.

By convention, the indexes are multiplied by 100 and reported as 113.3 instead of 1.133.

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 80,000 prices in 87 urban areas across the country are sampled by Bureau of Labor Statistics professionals. Visits and phone calls are made to thousands of households and thousands of retail stores and offices.

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

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 %

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:

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.

Questions

  1. If the annual rate of inflation is 4 percent a year and average income increases by 3 percent, what has happened to real average income?
    1. Decreased by 1 percent
    2. Decreased by 3 percent
    3. Increased by 1 percent
    4. Increased by 3 percent
    5. Increased by 7 percent
  2. Suppose the CPI was 100 one year, and was 105 the next year. What is the approximate annual rate of inflation for those 12 months?
    1. 5 percent
    2. 10 percent
    3. 10.5 percent
    4. 105 percent
  3. Suppose the CPI was 200 in one year and 220 in the next year. What was the annual rate of inflation for those 12 months?
    1. 5 percent
    2. 10 percent
    3. 20 percent
    4. 120 percent
    5. 220 percent
  4. Suppose a bicycle cost $200 in 1983 and a similar new bicycle costs $500? Given what you know about current 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. An automobile costs $15,000 in 1983. It costs $35,000 this year. What has happened to the price in 1983 dollars?
    1. increased
    2. decreased
    3. not changed
    4. one cannot tell.