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This lesson focuses on the Consumer Price Index (CPI) reported on February 20, 2008, by the U.S. Bureau of Labor Statistics for the month of January 2008. Students read the BLS report, read about the meaning of the CPI, determine the change in consumer prices, and explore how the change in the CPI impacts consumers and the economy. Students check their understanding by completing interactive exercises.

KEY CONCEPTS

Causes of Inflation, Economic Growth, Inflation, Interest, Interest Rate, Macroeconomic Indicators, Monetary Policy, Money, Money Supply, Price, Price Stability, Real vs. Nominal, Supply, Tools of the Federal Reserve, Trade-offs among Goals

STUDENTS WILL

  • Identify the rate and recent change in inflation in the U.S. in January 2008
  • Identify factors that influence changes in the inflation rate
  • Describe how inflation affects different groups in the economy
  • Identify the potential policies to reduce the rate of inflation

Current Key Economic Indicators

as of May 5, 2013

Inflation

On a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers decreased 0.2 percent in March after increasing 0.7 percent in February. The index for all items less food and energy rose 0.1 percent in March after rising 0.2 percent in February.

Employment and Unemployment

Total nonfarm payroll employment rose by 165,000 in April, and the unemployment rate was little changed at 7.5 percent. Employment increased in professional and business services, food services and drinking places, retail trade, and health care.

Real GDP

Real gross domestic product increased at an annual rate of 2.5 percent in the first quarter of 2013 (that is, from the fourth quarter to the first quarter), according to the "advance" estimate released by the Bureau of Economic Analysis. In the fourth quarter, real GDP increased 0.4 percent.

Federal Reserve

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent...

INTRODUCTION

This lesson focuses on the Bureau of Labor Statistics report of the Consumer Price Index in January, 2008.

The announcement:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The January level of 211.080 (1982-84=100) was 4.3 percent higher than in January 2007.

The Consumer Price Index for Urban Wage Earners and Clerical Workers CPI-W) increased 0.5 percent in January prior to seasonal adjustment. The January level of 206.744 (1982-84=100) was 4.6 percent higher than in January 2007.

The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 0.5 percent in January on a not seasonally adjusted basis. The January level of 121.895 (December 1999=100) was 3.9 percent higher than in January 2007.

[Note to Teachers: All paragraphs in italics will not appear in the student version of the inflation lesson. The original press release can be found at www.bls.gov/news.release/cpi.nr0.htm .]

MATERIALS


Key Economic Indicators

as of February 20, 2008

Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January, 2008, to 211.080.

Employment and Unemployment

The U.S. Unemployment Rate was 4.9% in January, 2008, a decrease of 0.1% from December, 2007. The Unemployment Level decreased by 17,000, to a total of 7.6 million unemployed..

Real GDP

Real gross domestic product increased at an annual rate of 0.6 percent in the fourth quarter of 2007.

Federal Reserve

The Federal Reserve lowered the target federal funds rate in two steps in January, 2008, by a total of 1.25% to 3.0%.

PROCESS

BLS Announcement:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The January level of 211.080 (1982-84=100) was 4.3 percent higher than in January 2007.

The Consumer Price Index for Urban Wage Earners and Clerical Workers CPI-W) increased 0.5 percent in January prior to seasonal adjustment. The January level of 206.744 (1982-84=100) was 4.6 percent higher than in January 2007.

The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 0.5 percent in January on a not seasonally adjusted basis. The January level of 121.895 (December 1999=100) was 3.9 percent higher than in January 2007.

What Really Happened to the Price Level?

U.S. Consumer prices rose faster in 2007 than in the past seventeen years. This trend has accelerated in the first month of 2008. In January, the indexes for food and for energy each advanced 0.7 percent.

The index for all items less food and energy rose 0.3 percent. Prices rose at a higher pace for apparel, medical care, recreation, education and communication, and for other goods and services.

Wages generally did not keep up with the increase in prices in 2007 and early 2008. Real average weekly earnings fell by 0.5 percent from December 2007 to January 2008 after seasonal adjustment. A 0.3 percent decrease in average weekly hours and a 0.4 percent increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) were partially offset by a 0.2 percent increase in average hourly earnings. Thus, the purchasing power of average wage earners was slightly eroded.

What is the Consumer Price Index?

The Consumer Price Indexes (CPI), reported by the Bureau of Labor Statistics, is a monthly measurement of changes in the prices paid by urban consumers for a representative 'market basket' of goods and services. An increase in the CPI from one month to another may be evidence of 'inflation' in the price level or a reduction in purchasing power.

The CPI measures changes in prices over time. By selecting an appropriate base year and setting the index level for that time period at 100, the CPI compares one months price index level with the base year or any other time period. The current standard reference base period is the average of the period from 1982 to 1084.

The CPI Market Basket

The CPI market basket represents all the consumer goods and services purchased by urban households. Price data are collected for over 180 categories, which BLS has grouped into 8 major groups. These major groups, with examples of categories in each, are as follows:

  • Food and beverages (ham, eggs, carbonated drinks, coffee, meals and snacks);
  • Housing (rent of primary residence, fuel oil, bedroom furniture);
  • Apparel (men’s shirts and sweaters, women’s dresses, jewelry);
  • Transportation (new vehicles, gasoline, tires, airline fares);
  • Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services);
  • Recreation (television sets, cable TV, pets and pet products, sports equipment, admissions);
  • Education and communication (college tuition, postage, telephone services, computer software and accessories);
  • Other goods and services (tobacco and smoking products, haircuts and other personal care services, funeral expenses).

What is Inflation?

Inflation is generally defined as 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.

There are several measurements or reported levels of the CPI. They are:

  • CPI: A measure of the average change in prices over time of goods and services purchased by households.
  • CPI-U: The Consumer Price Index for All Urban Consumers. Includes approximately 87 percent of the total population, including wage earners and clerical worker households, groups such as professional, managerial, and technical workers, the self-employed, short-term workers, the unemployed, retirees, and others not in the labor force.
  • CPI-W: The Consumer Price Index for Urban Wage Earners and Clerical Workers. Includes households of wage earners and clerical workers, representing approximately 32 percent of the total population.
  • C-CPI-U: The Chained Consumer Price Index for All Urban Consumers. This measurement uses a formula that reflects the substitutions consumers make in response to changes in relative prices.
  • Core CPI: The average price of the same set of goods and services, without some of the more volatile components, such as food and energy prices.

CPI Data Trends

The monthly rate of change in CPI in January was .5 percent, increasing at a 6.0 percent annual rate. The annual rate of change of the CPI was 4.6 percent in 2007. 2007 and early 2008 have seen a significant increase over the inflation rates 2.5 percent in 2005, 3.3 percent in 2004 and 1.9 percent in 2003.

On a seasonally adjusted basis, the CPI-U increased 0.4 percent in January, following increases of .3 percent in December, 2007, .8 percent in November and .3 percent in October. The CPI for all of 2007 increased by 4.1 percent, a significant increase over the CPI increase of 2.5 percent in 2006.

The core rate of inflation, the index for all items less food and energy rose 0.3 percent, following increases of 0.2 percent in each of the preceding nine months. This measurement represents changes in the consumer price index minus changes in the prices of food and energy, which can fluctuate widely from month to month. The indexes for food and for energy each advanced 0.7 percent, following increases in December of 0.1 and 1.7 percent, respectively.

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 were higher in the early part of the year and that did cause concern about the trend in inflation. The concern was that the increase in energy prices over the last several years may have started to influence rates of increases in all other prices. While that concern still exists, core prices are increasing at relatively slower rates.

The increase in the annual inflation rate in late 2007 and early 2008 is a significant change in the trend of the past several years. This is of great concern to policy makers who also face the trends of higher unemployment and slow growth in the same time period.

In recent years, reducing the potential of inflation has been the primary target of Federal Reserve monetary policy. With the recent jump in unemployment and a slower growth rate, the Fed faces the competing goals of maintaining stable prices and promoting growth. The Employment Act of 1956 established the goals of

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, it does appear that the monthly increases have been higher over the last two and a half years when compared to the previous three years.

Graph 1

Figure 2 shows the changes in the core index compared to the changes in the overall CPI. 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.

Graph 2

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.

Graph 3

Current Concerns About the Price Level

Figure 4 shows the annual rates of change in the overall CPI and in the core CPI. The trend since 2003 shows a rising overall and core CPI. Still, the increases for both indexes are low on an historical basis.

Graph 4

The Current Consumer Price Index

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The January level of 211.080 (1982-84=100) was 4.3 percent higher than in January 2007.

The Consumer Price Index for Urban Wage Earners and Clerical Workers CPI-W) increased 0.5 percent in January prior to seasonal adjustment. The January level of 206.744 (1982-84=100) was 4.6 percent higher than in January 2007.

The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 0.5 percent in January on a not seasonally adjusted basis. The January level of 121.895 (December 1999=100) was 3.9 percent higher than in January 2007.

On a seasonally adjusted basis, the CPI-U increased 0.4 percent in January. The Base Year for the CPI-U is 1982-84, meaning that 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 December, 2007 by 110.036 percent. A typical consumer good that cost one dollar in 1983 now costs just over $2.11.

What You Hear in the News

Typically, changes in the CPI or inflation are reported in the media in two ways, 1) The CPI (all sectors) and the 'core' rate of inflation that excludes food and energy prices. Historically, food and energy prices have fluctuated, risen up and down, at greater rates than other prices. Thus, the 'core' is those price categories that change more consistently. Recently, food and energy prices have more consistently risen at higher rates than other spending categories. Which measurement is more accurate? That depends on your spending habits.

Recent news reports have characterized the current economic conditions as 'stagflation,' a time when the economy faces slow growth/high unemployment (stagnation) and a higher price level(inflation). The chart below shows the U.S. unemployment and inflation figures for the last five years. The traditional theory had assumed that inflation and stagnation were opposing economic forces. Slow growth and high unemployment would keep prices low and high growth would be inflationary. The U.S. experiences of the 1980s with both high unemployment and high inflation, and the 1990s with low unemployment and low inflation seemed to put an end to this assumption.

Year CPI Change Unemployment Rate
Year
Increase/Decrease
Yearly CPI
2003 +2.3% 6.0%
2004 +2.7% 5.5%
2005 +3.4% 5.1%
2006 +3.2% 4.6%
2007 +2.8% 4.6%
2008 (Jan) +6.0%* 5.4%

*The .5 percent January change was an annualized change of 6 percent.

Watch the changes in unemployment and inflation rates in the coming months to see if the economy can have sustained unemployment and inflation. Watch for Federal Reserve Policies aimed at promoting growth and combating inflation. Can the Fed do both at the same time?

How Much Do You Actually Spend?

The CPI is a 'weighted index.' That is, not all categories of spending change in price level at the same rate. For instance, recently, food and energy prices have risen faster than the rates for other categories. In determining the overall rate, the BLS gives a 'weight' to each category. In calculating the index, price changes for the various items in each location are averaged together with weights, which represent their importance in the spending of the appropriate population group.

[Note to teacher: The determination of CPI and the rate of inflation is determined by averages. What does the 'average' person spend on each category? When an individual's spending pattern differs greatly from the 'average,' he or she will be more or less impacted by the rate of inflation. Families that spend a larger portion of their income on food will feel the pinch of January's inflation more than other.]

Month
Price Level
Monthly Inflation Rate
December 210.04

211.08- 210.04 = +1.04

210.04 divided by 1.04= .005 = .5 % monthly rate

.5% x 12 = 6% annual rate

January 211.08

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. Total cost of this 'market basket' in the base year was $600.00.

In the current year, the three goods' prices are $11, $24, and $33. Consumers now purchase 12, 8, and 11 of each good. The total current price of this 'market basket' is $622, but this would not be an accurate way to compare the 'price level.' An accurate comparison has to assume a constant pattern of purchasing.

The determination of the CPI for the current year uses 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 www.bls.gov .

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.

[Note to teacher: A number of exercises in Council for Economic Education publications, student workbooks, and textbooks should help students think about the consequences of inflation.]

To find information about Council for Economic Education publications, go to:http://store.ncee.net/

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 reduces the purchasing power of money. If your income is fixed or does not increase as much as the rate of inflation, you cannot purchase as many goods and services this year as you could last year. Your real income decreases.

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.

Inflation redistributes income. Those who owe money (borrowers) can repay it with inflated dollars (if their income increased to keep up with the inflation). Those who are owed money (lenders) receive dollars with less value when loans are repaid. Hopefully, the principal and interest received have at least the same purchasing power as the money loaned. In this situation, Income is redistributed from lenders to borrowers.

Discussion Questions

  1. What are the costs of inflation?
  2. Are there any benefits from inflation?
  3. Who is most impacted by inflation? Positively? Negatively?
  4. If inflation persists, how might it impact the overall economy?

CONCLUSION

  • The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in January before seasonal adjustment. The January level of 211.080 (1982-84=100) was 4.3 percent higher than in January 2007.
  • The Consumer Price Index for Urban Wage Earners and Clerical Workers CPI-W) increased 0.5 percent in January prior to seasonal adjustment. The January level of 206.744 (1982-84=100) was 4.6 percent higher than in January 2007.
  • Review the categories of goods and services included in the CPI (outlined earlier in this lesson).

Find information about the CPI 'market basket' at www.bls.gov/cpi/cpifaq.htm#Question_6

[Note to teacher: Ask the students which of these spending categories affects high school students more than others?]

ASSESSMENT ACTIVITY

Have the students click on the start button below to complete an interactive activity to test their knowledge on the CPI Lesson.

Next, have students complete the following questions in the interactive below.

 

  1. What is the difference between the CPI-U and the 'core' rate of inflation? [The Core rate excludes energy and foods prices, which tend to be more volatile.]
     
  2. Which measurement, the CPI-U or the core rate is the most meaningful measurement of inflation? [Answers will vary: Those concerned with the prices they currently pay for all goods and services, including energy and food, may see the CPI-U as more important. These are prices actually paid from one time to another. Consumers will typically base their spending plans on prices they currently pay or expect to pay. Inflation creates uncertainty about future purchasing power. Policy planners may look more at the core rate because energy and food prices have tended to go up and down over time, even if the longer term trend is upward. Planners must, necessarily, look at longer trend periods.]
     
  3. Which spending categories do you think have the greatest weight - what the BLS calls 'relative importance' - in determining the CPI? [The spending categories that have the greatest weight in determining the CPI according to the BLS 'relative importance' are: food and beverages 15.7 percent, housing 40.9 percent, apparel 4.4 percent, transportation 17.1 percent, medical care 5.8 percent, recreation 6.0 percent, education and communication 5.8 percent, other goods and services 4.3 percent, total all items 100.0 percent.]
     
  4. How do the BLS weights compare to your personal spending habits? How do they compare to how your family spends it income? [Answers will vary.]

EXTENSION ACTIVITY

Have the class role-play the Federal Reserve Open Market Committee.

Ask:

  1. Economic growth is slow, unemployment is rising and prices are rising. Which of these is the most critical problem?
  2. Can any one policy work to achieve the goals of promoting growth, full employment and stable prices?