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Announcement

The consumer price index (CPI) did not change during the month of November. The rate of increase in the consumer price index over the past twelve months has been 2.0 percent.

In November, the core consumer price index, which excludes energy and food prices, did not change. The core index has increased by 2.6 percent over the last twelve months.

Definition 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 November, the consumer price index did not change, after decreasing by .5 percent in September and in October. Energy prices fell significantly in September and October. In November, energy prices decreased onceagain but by a very small amount.

The annual rate of change over the last three months was a decrease of 3.9 percent. Over the last twelve months, we experienced an increase of 2.0 percent. Annual inflation rates from 2002 through 2005 were 2.4, 1.9, 3.3 and 3.4 percent.

The core rate of inflation (no change in November) 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 steady November core index compares to a .1 percent increase in October and .2 percent increase in each of the previous three months.

Extra attention is given by forecasters to the core index as it tends to show more lasting trends in prices. The rates of change in the core index had been increasing in the early part of this year and that did cause concern about the trend in inflation. The increase in energy prices over the last several years may have started to influence rates of increases in all other prices.

Figure 1 shows recent inflation data reported for each month. (November does not show, as there was no change.) It is obvious that the monthly inflation figures change a great deal from one month to the next. However, the trend had been an increasing one from 2004 until the last three months.

Figure 2 shows the changes in the core index compared to the changes in the overall CPI. (Again November does not show due to the zero changes.) Obviously the changes in prices other than energy and food have been significantly smaller than the changes in the overall index. That is due to the much greater volatility in energy and food prices.

Figure 3 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 of inflation, over the last three years, 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.

Current concerns

Excluding the last three months, the rate of inflation appears to be increasing. The causes are likely to be the effects of relatively low interest rates causing a healthy growth in spending. The second is the rapid rise, over the last three years, in petroleum and gasoline prices raising the prices of energy and raising costs of producing a wide variety of goods.

Figure 4 shows the annual rates of change in the overall CPI and in the core CPI. (It also includes figures for 2006 to date.) The trend since 2003 shows a rising core CPI. There appears to be a declining inflation rate in the overall index when 2006 is included. Still, the increases for both indexes are low on an historical basis.

The chairman of the Federal Reserve and others have stated that the present trend in increasing rates of inflation may be met with an increasingly restrictive monetary policy. It is that rising core index that is of concern. (See the discussion of monetary policy below and the most recent Federal Reserve case study.)

The Consumer Price Index

The seasonally adjusted consumer price index in November was 201.7. 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 November, 2006 by 101.7 percent. A typical consumer good that cost one dollar in 1983 now costs $2.02.

Inflation is announced and reported in newspapers and television news as percentage changes in the CPI on a monthly basis. For example, the core CPI in October increased by .1 percent. The approximate annual rate of increase can be calculated by multiplying the .1 percent by 12 months. Thus the annual rate of core inflation in October was 1.2 percent.

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.

CPI Interactive Exercise

Causes of Inflation

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.

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.

Full employment

Economists define the approximate unemployment rate, at which there are not upward or downward pressures on wages and price, as full employment rate of unemployment. If unemployment falls to level below the full employment rate, there will be upward pressure on wages and prices. If unemployment rises to a very high rate, there will downward pressure on wages and prices or wages and prices will remain steady. In the middle is a level, or more likely a range, where there is not pressure on wages and prices to rise or fall.

Economists do not know for certain what that unemployment rate is, and even if they did, it does change over time. A current consensus estimate is that the full employment rate of unemployment is currently between 4.0 and 4.7 or 4.8 percent of the labor force being unemployed. That is if unemployment were to fall to 4.0 percent of the labor force or below, there will increased upward pressure on wages and that may cause prices to begin to increase. If unemployment were 6.0 percent, workers competing for jobs may cause wages to fall. Costs of producing fall and prices may fall. Or at least not increase as rapidly.

Policy discussion question

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

Questions