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Announcement

The consumer price index (CPI) during the month of November decreased by .6 percent (six-tenths of one percent). The rate of increase in the consumer price index over the past twelve months has been 3.5 percent.

In November, the core consumer price index, which excludes energy and food prices, increased by 0.2 percent. The core consumer price index has increased by 2.1 percent over the last twelve months.

Please do the following multiple choice activity.

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 fixed set of goods relative to the cost of those same goods in a previous month or year. Changes in the prices of those goods approximate changes in the overall level of prices paid by consumers.

Data Trends

In November, the Consumer Price Index decreased by .6 percent, after increasing 1.2 percent in September and .2 percent in October. In November, housing, education, and communication prices increased by the largest portions. The prices of medical care also increased rapidly during the month.

The core rate of inflation (.2 percent) represents the consumer price index without the influences of changes in the prices of food and energy, which can and do fluctuate widely from month to month. The November increase compares to a .2 percent increase in October and .1 percent increases in the core rate of inflation in every other month since April when it did not change.

Figure 1 shows recent inflation data reported for each month. It is obvious that the monthly inflation figures change a great deal and that rates of inflation are not very stable from one month to the next. The rates appear to vary more in 2003 through 2005 than in prior years.

Figure 1: Monthly Inflation in Consumer Prices at Monthly Rates

Figure 2 adds the core index in a dashed, red line. The core index does not vary as much as the CPI as oil and food prices have been particularly volatile in the last three years. 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 and why it is the primary focus of the Federal Reserve when it is evaluating inflation and inflationary pressures.

Figure 2: Monthly Inflation in Consumer Prices at Montly Rate

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 for annual rates of inflation throughout that entire period. 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.

Figure 3: Inflation in Consumer Prices, 1970 - 2005, Annual Rate of Change

Deflation

Overall prices fell this month and have fallen over brief periods, as they did in one month in 2004 and 4 months in 2003. In fact, inflation was so low in 2001 and 2002, many observers were concerned about the possibility of deflation.

Deflation, however, is defined as a sustained decrease in the overall level of prices, that is, a continual fall in prices. A one month decrease in prices does not mean that we are experiencing deflation. Only if it continued for several months and showed in the core CPI would we begin to speak of the existence of deflation.

Deflation may sound like a good event, but we have to remember that it 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 November was 197.8. 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 November 2005 by almost 100 percent. That is, they have almost doubled.

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 November was 197.8, compared to 198.9 in October. The decrease in prices from October to November was (197.8 - 198.9) / 198.9 = minus 0.006 or a monthly deflation rate of .6 percent.

To convert this into an annual rate, one can multiply this monthly rate by 12. The assumption is that if this same rate continued for twelve months, inflation (or deflation) would 12 times the monthly rate. This approximates an annual deflation rate of (- .6) (12) = - 7.2 percent.

Table 1
Month Price Level Monthly Inflation Rate
November 197.8
197.8 - 198.9 = -.0055 or - .6%

198.9
October 198.9

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 (say 2004), the goods had prices of $10.00, $20.00, and $30.00. The typical consumer purchased ten of each good. See table 2.

Table 2
  2004 2005
  Prices Quantities Prices Quantities
Good 1 $10 10 $11 12
Good 2 $20 10 $24 8
Good 3 $30 10 $33 11

In the current year (2005), the goods’ prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good.

CPI Interactive Exercise

Explanation

The CPI for 2005 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 index is 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 CPI is based on prices of food, clothing, housing, transportation, and all the other goods and services that people purchase on a regular basis. Forty percent of those prices are prices of goods; sixty percent are prices of 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.

The relative importance of each of the categories of goods and services that are 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 %    

Prices are collected through phone interviews and visits in almost 90 cities around the country. Almost 25,000 grocery stores, clothing stores, service stations, hospitals, and other retail stores are included. Fifty thousand families are interviewed.

For more information on the Bureau of Labor Statistics, visit [EEL-link id='1216' title='www.bls.gov' ].

CPI Interactive Exercise

Click here for an online interactive exercise.

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.

  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.

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.

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