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This lesson focuses on the Consumer Price Index (CPI) and rate of inflation reported October 16, 2008, by the U.S. Bureau of Labor Statistics for the month of September, 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 WILL

• Identify the rate and recent change in the consumer price index and rate of inflation in the U.S. in September, 2008.
• Identify factors that have influenced recent changes in the inflation rate.
• Describe how inflation impacts individuals, families, and different groups in the economy.
• Distinguish between and evaluate the various measurements of inflation.

### Current Key Economic Indicators

as of November 30, -0001

### INTRODUCTION

Each month, the U.S. Bureau of Labor Statistics (BLS) releases an estimate of the rate of inflation in the United States for the previous month. This Lesson focuses on the BLS report of the Consumer Price Index (CPI)in September, 2008.

The report provides the most recent current and seasonally adjusted consumer price indexes for all urban consumers, urban wager earners, and the chained index, plus a breakdown by major expenditure groups.

BLS announcement, October 16, 2008: Consumer Price Index: September 2008

"The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1 percent in September, before seasonal adjustment, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. The September level of 218.783 (1982-84=100) was 4.9 percent higher than in September 2007.

The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) decreased 0.1 percent in September, prior to seasonal adjustment. The September level of 214.935 (1982-84=100) was 5.4 percent higher than in September 2007.

The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) decreased 0.1 percent in September on a not seasonally adjusted basis. The September level of 125.774 (December 1999=100) was 4.3 percent higher than in September 2007.

On a seasonally adjusted basis, the CPI-U was virtually unchanged in September following a 0.1 percent decrease in August."

### RESOURCES

• Bureau of Labor Statistics October 16, 2008, release of CPI Data: This release by the BLS focuses on the Consumer Price Index of September, 2008.
www.bls.gov/news.release/archives/cpi_10162008.htm

www.bls.gov/cpi/cpifaq.htm

• Inflation Calculator:  This calculator allows visitors to compare price changes over time due to inflation.
data.bls.gov/cgi-bin/cpicalc.pl

• How BLS Measures Changes in Consumer Prices:  This article explains how the BLS keeps track of a change in consumer prices:
www.bls.gov/cpi/cpifact2.htm

• Council for Economic Education Publications:  This site provides a large number of student workbooks, textbooks, and lesson plans that could help students to think about inflation.
store.councilforeconed.org/

• Assessment Activity:  This interactive assessment will test students on their understanding of CPI.
Interactive Activity

• The Consumer Price Index-- Why the Published Averages Don't Always Match an Individual's Inflation Experience:  This article explains the idea that the CPI is an average, and may not reflect your own personal experience.
www.bls.gov/cpi/cpifact5.htm

### Key Economic Indicators

as of October 16, 2008

#### Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1 percent in September, before seasonal adjustment. The September level of 218.783 was 4.9 percent higher than in September 2007.

#### Employment and Unemployment

U.S. non-farm payroll employment declined by 159,000 in September, and the unemployment rate held at 6.1 percent in Septembeer. Employment continued to fall in construction, manufacturing, and retail trade, while mining and health care added jobs.

#### Real GDP

U.S. real gross domestic product increased at an annual rate of 2.8 percent in the second quarter of 2008, (that is, from the first quarter to the second quarter). In the first quarter, real GDP increased 0.9 percent.

#### Federal Reserve

At its September 16 meeting, the Federal Open Market Committee decided to keep its target for the federal funds rate at 2 percent. (September 16, 2008) In an unscheduled announcement on October 8, 2008, the FOMC lowered its target for the federal funds rate 50 basis points to 1-1/2 percent.

### PROCESS

In its announcement, the BLS breaks down the September consumer price data by major industry group.

"The index for energy fell 1.9 percent in September following a 3.1 percent decline in August. The motor fuel index declined 0.8 percent in September but was 31.8 percent higher than a year ago. The index for household energy fell 3.4 percent in September after a 1.6 percent decrease in August.

The food index advanced 0.6 percent in September, the same increase as in August. The index for food at home rose 0.6 percent in September after a 0.8 percent rise in August and is up 7.6 percent over the past year.

The index for all items less food and energy increased 0.1 percent in September, decelerating for the second straight month. Contributing to the deceleration were downturns in the indexes for apparel and for airline fares, a smaller increase in the index for recreation, and a steeper decline in the index for new and used motor vehicles. These more than offset an upturn in the index for lodging away from home and larger increases in the indexes for medical care and owners' equivalent rent."

Table 1 shows a breakdown of the CPI changes by major expenditure category, July-September, 2008

 Table 1. Percent changes in CPI All Urban Consumers (seasonally adjusted) Expenditure Category Changes from proceeding month Compound Annual Rate for 3 mos. Ended Unadjusted for 12 mos. Ended July 2008 Aug. 2008 Sept. 2008 Sept. 2008 Sept. 2008 All items .8 -.1 .0 2.6 4.9 Food & Beverages .9 .6 .5 8.5 6.0 Housing .6 -.1 -.1 1.8 3.5 Apparel 1.2 .5 -.1 6.6 1.4 Transportation 1.7 -1.5 -.6 -1.7 10,5 Medical Care .1 .2 .3 2.5 3.2 Recreation .4 .5 .2 4.6 2.4 Education/Communication .5 .2 .1 3.3 3.5 Other goods and services .4 .2 .2 3.3 4.0 Special indexes: Energy 4.0 -3.1 -1.9 -4.9 23.1 Food .9 .6 .6 8.7 6.2 All items less food    and energy .3 .2 .1 2.7 2.5

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.

To read more about how the BLS measures price changes, see How BLS Measures Changes in Consumer Prices .

What is Inflation?

Inflation is generally defined by the BLS as "a process of continuously rising prices, or equivalently, of a continuously falling value of money." 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.

If the prices of goods and services increase, the purchasing power of a dollar of income decreases. If prices increase by 5 percent, and your income remains the same, you can't purchase as many goods and services with your income. If your income increases by 5 percent and prices increase by 5 percent, the inflation negates your increase in income. Your 'real' income does not increase.

The media often mentions the “core rate” of inflation and the “headline rate.” What is the difference?

Typically, changes in the CPI or inflation are reported in the media in two ways, 1) The CPI (all sectors) and 2) the 'core' rate of inflation that excludes food and energy prices. The overall CPI data is often referred to as the 'headline number' because that number is reported in the news.

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 is 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. Recent decreases in energy prices have somewhat reduced the difference between the reported rate and the core rate.

[Note to teachers: There are several other measurements of “inflation.”]

The Consumer Price Index for All Urban Consumers (CPI-U) measures the price of a “basket” of goods and services in urban areas. This is the most commonly used measurement of changes in the price level.

The Producer Price Index (PPI) measures the average change in wholesale prices – the prices paid by producers for inputs.

Core inflation is the CPI, excluding food and energy prices, which are historically more volatile.

The Personal Consumption Expenditures (PCE) deflator measures the total cost of expenditures. Example: The total cost of pharmaceutical drugs is counted in the PCE index, while only the consumer's insurance co-pay is counted in the CPI.

The GDP deflator (implicit price deflator for GDP) is a measure of the change in prices of all new, domestically produced, final goods and services in an economy.

The Employment Cost Index (ECI) measures changes in the costs of labor for businesses in the United States.

Recent U.S. Inflation Trends

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.

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.

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.

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 up to now.

"Stagflation"

Some recent news reports characterized recent economic conditions as 'stagflation,' a time when the economy faces slow growth/high unemployment (stagnation) and a higher price level (inflation). Table 2 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. See Table 2. In the last two months, inflationary pressures have eased primarily because energy and commodity prices have fallen.

 Table 2: Yearly Change in CPI and the Unemployment Rate Year CPI Change Unemployment Rate 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 4.5% * (Jan.-Sept) 6.1% (Sept.) *The January-Sept. 2008 CPI change is reported here as annualized change

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?

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.

What happens when the price level rises? What difference does it make?

Your income determines how many goods and services you can consume. An individual or family will create a budget or spending plan based on how much income they have to spend and save. They will determine how much they can afford to buy with their “spending power.” Their “spending power” is a function of their available income and the prices of the goods and services they want to buy.

Suppose the Smith family has a net (after taxes and other deductions) income of \$3,000 per month. With that income they can pay for their housing, food, transportation, utilities, entertainment, etc. They may even be able to save some of it. They base their “lifestyle” on their ability to purchase what they want.

When inflation happens and prices of many of the things they buy go up, their “spending power” decreases. Suppose the inflation in a year is 5 percent. Assume that everything they buy now costs 5 percent more. They simply can’t buy as many goods and services. To purchase the same goods and services they consumed last year will cost them \$3,150 per month this year. Either they have to earn another \$150 in income to maintain their lifestyle or they have to give up \$150 in spending. In a year, they will need an additional \$1,800 just to keep up with inflation. If they don’t have \$1,800 more, they will have to give up \$1,800 in spending or saving. (Let’s assume they don’t want to use credit and accumulate more debt to keep the same spending level.)

When prices rise and \$3,000 in income will not purchase as much as it used to, the family’s “real income” is reduced. Real income is the family’s nominal income (current dollar income) reduced by the effect of inflation.

One hundred fifty dollars doesn’t sound like much, but what if their income is fixed for several years? What if inflation is 10 percent and they need \$300 more in net income? That’s how inflation impacts us. Inflation reduces purchasing power because each dollar of income can buy fewer goods and services.

Those who are able to earn additional income or negotiate a raise from their employers may be able to keep up. They may even be able to increase their real income if their raise is greater than the rate of inflation.

Focus on Economic Data

Take a look at the income of three families.

• Mr. and Mrs. Blue live on a fixed net income of \$3,000 (\$36,000 annually).

• Mr. and Mrs. Brown also have a net income of \$3,000, but they receive a 5 percent raise each year.

• Mr. and Mrs. Green also have a net income of \$3,000 per month, but they are able to increase their income by 10 percent each year.

Look at what happens to each family’s real income or purchasing power over three years during a time of 5 percent annual inflation.

 Table 3 Focus on Economic Data Family Blue Brown Green Current Income – year 1 \$36,000 \$36,000 \$36,000 Real income – year 1 \$36,000 \$36,000 \$36,000 Income increase – years 1-2 0 \$1,800 \$3,600 Current Income – year 2 \$36,000 \$37,800 \$39,600 Inflation – years 1 to 2 (5%) -\$1,800 -\$1,800 -\$1,800 Real income – year 2 \$34,200 \$36,000 \$37,800 Income increase – years 2-3 0 \$1,890 \$3,960 Current Income – year 3 \$36,000 \$39,690 \$43,560 Inflation – years 2 to 3 (5%) -\$3,690 -\$3,690 -\$3,690 Real income – year 3 \$32,310 \$36,000 \$39,870

How has inflation affected each family’s real income or purchasing power?

• The Blue family has lost \$3,690 in purchasing power in just two years. Their real income has decreased. They have to give up \$3,600 in spending or saving.

• The Brown family maintained their real income (purchasing power) and with increases in income they have kept pace with the 5 percent rate of inflation.

• The Green family has greater real income (purchasing power) because they have been able to increase their income more than the 5 percent rate of inflation.

[Note to teachers: A number of exercises in Council for Economic Education Publications , student workbooks, and textbooks should help students think about the consequences of inflation. Click here for BLS answers to Frequently Asked Questions About the CPI .]

### ASSESSMENT ACTIVITY

Discussion Questions

1. Which measurement, the CPI-U or the core rate, is the most meaningful? [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 prices are waht they actually pay 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. Planers must look at longer-trend periods.]

2. How can borrowers benefit from inflation? [Assuming that the borrower's income rises with the inflation, the borrower is repaying a loan with "cheaper dollars." Suppose she earned \$10 an hour in Year 1 and borrowed \$100 for one year at 5 percent interest. In Year 2, her income increased to \$100 an hour. If she repaid the loan in Year 2 (\$100 plus \$5 interest), it took her fewer hours to earn the income to repay the loan. Her income inflated, but her debt did not - even with the 5 percent interest.]

3. If a country's nominal GDP increased from \$15 trillion to \$16 trillion from one year to the next, explain what has happened to real GDP? Assume that the GDP Price Index (a similar measure of inflation) was 150 in the first year and 160 in the second year. [The level of real GDP has stayed about the same from one year to the next. "Real" means adjusted for inflation. The percentage increase in the nominal GDP was offset by the same percentage increase in the price level. The result is no increase in real output.]

### CONCLUSION

Review:

Inflationary pressures in the U.S. economy eased somewhat in September. The Consumer Price Index was largely unchanged from August. The CPI is a measure of the average change in the prices of a “basket” of goods and services purchased by households over time.

The Consumer Price Index for All Urban Consumers (CPI-U) decreased 0.1 percent in September, 2008, before seasonal adjustment.

The September level of 218.783 (1982-84=100) was 4.9 percent higher than in September 2007.

The index for energy fell 1.9 percent in September following a 3.1 percent decline in August. The motor fuel index declined 0.8 percent in September but was 31.8 percent higher than a year ago.

The food index advanced 0.6 percent in September, the same increase as in August. The index for food at home rose 0.6 percent in September after a 0.8 percent rise in August and is up 7.6 percent over the past year.

The index for all items less food and energy increased 0.1 percent in September, decelerating for the second straight month.

What do you think lies ahead?

Inflation Calculator : Students can determine the rates of inflation for years between 1913 and 2008 with the BLS 'Inflation Calculator.'

### EXTENSION ACTIVITY

CPI is a “Weighted” Index

The BLS announcement mentions, “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.” This recognizes that people do not have the same spending patterns. This also means that price level changes for various goods and services affect people differently.

A high school student who spends a large portion of his or her income on transportation, clothing, and entertainment is more greatly affected if those prices change. If you do not pay rent, housing prices are not a very important part of your cost of living. When the price of gasoline falls, the student who spends much of his or her income on gasoline will gain purchasing power.

When housing costs (rents or rental equivalents) increase, the family that spends a large portion of their income on rent may lose purchasing power, even if other prices do not increase as much. Someone who lives in a large city and does not drive may not be affected very much by changes in gasoline prices.

Determine your own 'Personal Price Index,' by determining the percentage of your spending in each category. This will give you your own 'weights' for each spending category. See the 'hypothetical individual' example in the reading.

How are you affected by inflation compared to the average urban consumer and each other? Do you spend a larger percentage of your income on automobiles, gasoline, or entertainment?

How does inflation impact you, your family, and other demographic groups?