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This lesson focuses on the Consumer Price Index (CPI) and rate of inflation reported January 15, 2010, by the U.S. Bureau of Labor Statistics for the month of December 2009. Students will 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.

KEY CONCEPTS

Business Cycles, Causes of Inflation, Consumer Price Index (CPI), Macroeconomic Indicators, Price Stability, Real vs. Nominal

STUDENTS WILL

  • Identify the rate and recent change in the CPI and rate of inflation in the U.S. in December 2009.
  • Identify factors that have influenced recent changes in the inflation rate.
  • Describe how inflation impacts different groups in the economy.
  • Distinguish between the core rate and the more broad measures 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

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. 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. The BLS also collects price level data for major metropolitan areas and regions.

This "Focus on Economic Data" lesson focuses on the U.S. Bureau of Labor Statistics announcement dated January 15, 2010 on the "Consumer Price Index: December 2009." 
     
[Note to teachers: In the second semester of the 2009-2010 school year (January -May), EconEdLink will publish five lessons on "Consumer Price Index and Inflation." During this time period, the Focus on Economic Data lessons will begin with the "basic concepts" in January and progressively focus on more complex data, issues, and comparisons. All monthly lessons will include the current data and significant recent changes.

  • January: CPI and inflation (deflation) basics: What is the CPI? What is inflation and deflation? How are they measured? What do they mean?
  • February: Details and issues about the measurements and meaning of the measurements of the price level, adding additional concepts.
  • March: Detailed breakdown of the data by region and other criteria (trends, identifying trends and comparisons of regions and demographic groups).
  • April: The relationships of CPI and inflation data to other economic data, such as GDP, employment. etc. and the business cycle.]
  • May:  End of school year summary of the CPI changes and rate of inflation.

MATERIALS


Key Economic Indicators

as of January 15, 2010

Inflation

On a seasonally adjusted basis, the December Consumer Price Index for All Urban Consumers (CPI-U) rose 0.1 percent. Over the last 12 months, the index increased 2.7 percent before seasonal adjustment.

Employment and Unemployment

Non-farm payroll employment edged down (-85,000) in December, and the unemployment rate was unchanged at 10.0 percent. Employment fell in construction, manufacturing, and wholesale trade, while temporary help services and health care added jobs. The November 2009 estimate of employment was adjusted to indicate a net gain of 4,000 jobs.

Real GDP

Real gross domestic product increased at an annual rate of 2.2 percent in the third quarter of 2009. according to the "third" estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP decreased 0.7 percent.

Federal Reserve

The Federal Open Market Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

PROCESS

Economic News Release: Consumer Price Index Summary – December 2009

U.S. Department of Labor, Bureau of Labor Statistics

Released: January 15, 2010 

“On a seasonally adjusted basis, the December Consumer Price Index for All Urban Consumers (CPI-U) rose 0.1 percent, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the index increased 2.7 percent before seasonal adjustment.

As measured by the CPI-U, U.S. prices increased at a very low rate in December 2009, compared to the increases experienced in recent months. If the increases continue at this rate, the total increase in the CPI-U for the next year will be only 1.2 percent. Unfortunately, monthly increases are not usually consistent, as there are many variables that influence prices. Some of those factors will be identified in this lesson.

The current (December 2009) measurement of CPI-U is 211.703. That is, from a level of 100 in 1982-84, prices have increased by 111.703 percent. A market basket of goods and services that cost a consumer $100 in 1982-84 cost a consumer $211.70 in December 2009. One key to the real meaning of this number is whether or not consumers’ incomes have kept pace and their purchasing power is equal to or greater than it was in 1982-84.

What is the Consumer Price Index?

The Consumer Price Indexes (CPI), reported by the U.S. Bureau of Labor Statistics, part of the U.S. Department of Labor, 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 over time 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 month's 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 1984.

To see how the CPI works, you can go to the BLS CPI Calculator. The CPI Inflation Calculator allows you to calculate the value of current dollars in an earlier period, or to calculate the current value of dollar amounts from years ago. Consumer Price Indexes often are used to escalate or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.

[Note to teachers: Students can be assigned various time periods or historical events.  The can determine what consumer prices were at that time. One other idea to discuss is how lifestyles or commonly used goods and services compare from that time to today.  For instance, the consumer price index of just 10-15 years ago will not reflect the many new uses of technology available to consumers today.]

Highlights of the January 15 News Release

“The seasonally adjusted increase in the all items index was broad based, with the indexes for food, energy, and all items less food and  energy all posting modest increases. Within the latter group, a sharp rise in the index for used cars and trucks was the largest contributor to the 0.1 percent increase, while the indexes for airline fares, apparel, and lodging away from home rose as well.  In contrast, the indexes for rent and owners' equivalent rent were unchanged and the index for new vehicles declined.

The CPI increase in December could reflect some of the factors influencing the overall health of the economy. The end of the “cash for clunkers” program that had a positive impact on the demand for new automobiles ended. Housing prices continue to reflect a depressed housing industry and real estate markets. The increases in prices for airline seats, apparel and lodging may reflect moderately renewed consumer demand for those goods and services.

“Grocery store food indexes showed broad-based increases, leading to the food index rising 0.2 percent, its largest one-month advance in over a year. The energy index also rose 0.2 percent; this was its smallest increase in five months. The indexes for fuel oil and gasoline rose, but the electricity index was unchanged and the natural gas index declined.”

Food and energy prices, those not include in the “core” price index, both increased more than the overall price level – though still only moderate increases of 0.2 percent. Food and energy prices have recently proven to be more volatile than the “core” index goods and services.

2009 – The Year in Review

“For the 12 month period ending December 2009, the CPI-U rose 2.7 percent, compared to 0.1 percent for 2008.  The larger increase was primarily due to the energy index, which rose 18.2 percent during 2009, after falling 21.3 percent in 2008. The energy upturn was caused by the gasoline index, which rose 53.5 percent in 2009 after declining 43.1 percent in 2008. The household energy index, in contrast, declined 4.9 percent during 2009 with the index for natural gas falling 18.1 percent and the electricity index declining 0.5 percent.”

“The food index, which rose 5.9 percent in 2008, fell 0.5 percent for the 12 months ending December 2009, the first December-to-December decline since 1961. The index for food away from home rose 1.9 percent while the food at home index fell 2.4 percent. Within food at home, all six major grocery food groups posted declines in 2009 after rising in 2008. The dairy and related products group declined the most, falling 7.6 percent, its largest annual decline since 1938.”

“The index for all items less food and energy rose 1.8 percent during 2009, the same increase as in 2008. This identical increase was the result of offsetting factors. Pushing the index higher were vehicle prices, which rose in 2009 after declining in 2008. The indexes for new vehicles rose 4.9 percent in 2009 and the index for used cars and trucks increased 9.2 percent. Additionally, the apparel index turned up in 2009, rising 1.9 percent after declining in each of the previous two years. The medical care index rose more rapidly in 2009, increasing 3.4 percent after a 2.6 percent increase the previous year, and the tobacco index increased 30.1 percent in 2009 after rising 6.3 percent in 2008. Largely offsetting these accelerations was the shelter index, which posted its smallest annual increase since its inception in 1953. It increased only 0.3 percent after increasing 1.9 percent in 2008, with the indexes for both rent and owners' equivalent rent increasing 0.7 percent. Also, the indexes for recreation and for household furnishings and operations both declined in 2009 after rising in 2008.”

Overall, the rate of inflation in the United States in 2009 was moderate by long-term historical standards though much more than the past couple of years when prices reflected the serious economic downturn. If you take a look at the EconEdLink CPI lessons for the past couple of years, you will read about the impact of the recession on prices, beginning in late 2007.

Energy prices continue to be the most volatile and have not followed the trends of overall prices in the U.S. in the last couple of years. While the overall index increased by 2.7 percent over 12 months, the “core” index increased by only 1.8 percent. A look at the EconEdLink lesson over recent years will quite often show that energy price changes (up and down) often go against or go beyond the overall price level trend.

[Note to teachers:  Talk with students about their experiences with prices in 2009.  Did they notice any significant price changes?  If they drive, they are probably very aware of month-to-month changes in gasoline prices.]

Not seasonally adjusted CPI measures

The data in the initial announcement is “seasonally adjusted” or they “eliminate the effect of changes that normally occur at the same time and in about the same magnitude every year--such as price movements resulting from changing climatic conditions, production cycles, model changeovers, holidays, and sales.”

The BLS also reports the “not seasonally adjusted” price level data because “the unadjusted data are of primary interest to consumers concerned about the prices they actually pay. Unadjusted data also are used extensively for escalation purposes. Many collective bargaining contract agreements and pension plans, for example, tie compensation changes to the Consumer Price Index before adjustment for seasonal variation.” Source: Seasonal Adjustment in the CPI .

“The Consumer Price Index for All Urban Consumers (CPI-U) increased 2.7 percent over the last 12 months to an index level of 215.949 (1982-84=100). For the month, the index decreased 0.2 percent prior to seasonal adjustment.”

“The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) increased 3.4 percent over the last 12 months to an index level of 211.703 (1982-84=100). For the month, the index decreased 0.1 percent prior to seasonal adjustment.”

“The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 2.8 percent over the last 12 months. For the month, the index declined 0.2 percent on a not seasonally adjusted basis. Please note that the indexes for the post-2007 period are subject to revision.”

[NOTE: The BLS explains the meaning of “seasonally adjusted” data.]

“By using seasonally adjusted data, some users find it easier to see the underlying trend in short-term price changes. It is often difficult to tell from raw (unadjusted) statistics whether developments between any 2 months reflect changing economic conditions or only normal seasonal patterns. Therefore, many economic series, including the CPI, are adjusted to remove the effect of seasonal influences-those which occur at the same time and in about the same magnitude every year. Among these influences are price movements resulting from changing weather conditions, production cycles, changeovers of models, and holidays.” Source: BLS, When Should I use Seasonally Adjusted Data?

Real vs. Nominal Measurements
 
In many cases, data should be adjusted for a change in the price level to make comparisons over time more meaningful. The term "nominal" is used to refer to a measurement in current dollars. To adjust for inflation and determine a "real" value, the nominal value is adjusted by the price level change. A measurement such as gross domestic product in nominal terms refers to the measurement at current dollars (prices.) To compare GDP in two years, the rate of inflation between the years must be subtracted to determine the real change. 

The same is true for income and purchasing power. Suppose Mr. Jones made $50,000 in 2008 and $52,000 in 2009.  His income increased by $2,000 or 4 percent from 2008 to 2009. If the rate of inflation between 2008 and 2009 was 5 percent, Mr. Jones' purchasing power actually decreased by 1 percent. His 4 percent increase in income did not purchase the same amount of goods and services as it did in the previous year.  Inflation reduced his purchasing power.

Did Incomes Keep up with Prices?

Also on December 15, the BLS issues a news release on “Real Earnings – December 2009.” This report confirmed that in December, average wages just kept pace with inflation. “Real average hourly earnings did not change from November to December, seasonally adjusted, the Bureau of Labor Statistics reported today. A 0.2 percent increase in average hourly earnings for production and nonsupervisory workers was offset by a 0.2 percent increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).”

“Real average weekly earnings (were) unchanged over the month, seasonally adjusted. This stems from no change in real average hourly earnings and in average weekly hours. Since reaching a recent high point in December 2008, real average weekly earnings have fallen by 1.6 percent.” Over the year, wages have fallen behind prices."

"Real average hourly earnings fell 1.3 percent, seasonally adjusted, from December 2008 to December 2009. A 0.3 percent decline in average weekly hours combined with the decrease in real average hourly earnings resulted in a 1.6 percent decrease in real average weekly earnings during this period."  Over the year, wages have fallen benind prices.

[Note to teachers: This may be a good topic for student duscussion. What happens if wages do not keep pace with prices?  Even better, although average wages have not kept up, some worker's wages have and some haven't.  What does this mean for the economy?]  Source: Real Earnings-Decembers 2009

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, and 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. If the price level of consumer goods and services increases over a period of time, the consumer's purchasing power decreases (assuming, of course, that the consumer's disposable income and spending pattern remain the same).

Just the opposite of the definition of inflation, deflation is generally defined as a continual decrease in the overall level of prices. It is a decrease in average prices that lasts at least a few months. If the price level of consumer goods and services decreases over a period of time, the consumer's purchasing power increases (assuming, again, that the consumer's disposable income and spending pattern remain the same.
 

What Happened to the CPI Market Basket's Prices in December and 2009?

Figure 1 shows the increases or decreases in the price level of several components of the CPU-U. Note that while some prices increased significantly, other categories of spending increased very little or decreased. How price changes in 2009 impacted you are a result of your personal spending patterns. The CPI is an assessment of the impact of price changes on an "average" urban consumer with an "average" spending pattern. If you spend a large portion of your income on energy, you were impacted more in 2009 than someone who does not spend as much on energy.

Figure 1:  Changes in CPI All Urban Consumers
U.S. City Average
December 2009
(Seasonally adjusted)
  Dec 2009 12 months Dec.-Dec.
All Items 0.1 -2.7
   Food 0.2 -0.5
   Food at home 0.3 -2.4
   Food away from home 0.1 1.9
   Energy 0.2 18.2
   Energy commodities 0.5 46.5
   Gasoline 0.0 -0.5
   Fuel oil 1.1 6.5
   Energy services -0.1 -5.4
   Electricity 0.0 -0.5
All Items less food and energy 0.1 1.8
   New vehicles -0.3 4.9
   Used cars and trucks 2.5 9.2
   Apparel 0.4 1.9
   Medical care commodities -0.1 3.3
   Shelter 0.1 1.4
   Transportation services 0.3 3.9
   Medical care services 0.2 3.4

Consumer Price Index Data for December 2009 – Highlights

Food   “The food index rose 0.2 percent in December after rising 0.1 percent in each of the previous two months. The food at home index increased 0.3 percent, its largest increase since October 2008. Among the major grocery store food groups, the index for meats, poultry, fish, and eggs was unchanged while the other five groups all posted increases. The index for cereals and bakery products rose 0.6 percent, while the dairy and related products index increased 0.5 percent after declining 0.7 percent in November. The indexes for fruits and vegetables and for other food at home both rose 0.3 percent while the index for nonalcoholic beverages increased 0.2 percent. The index for food away from home increased in December, rising 0.1 percent after increasing 0.2 percent in November.”

Energy   “The energy index, which increased 4.1 percent in November, rose 0.2 percent in December. The index for energy commodities increased 0.5 percent, with the gasoline index rising 0.2 percent after increasing 6.4 percent in November. (Before seasonal adjustment, gasoline prices declined 1.5 percent in December.) The index for household energy was unchanged in December. The fuel oil index rose 1.1 percent after a 9.0 percent increase in the previous month, but the index for natural gas fell 0.7 percent. The index for electricity, which increased 1.4 percent in November, was unchanged in December.”

All Items Less Food and Energy  “The index for all items less food and energy rose 0.1 percent in December after being unchanged in November. The index for used cars and trucks rose 2.5 percent in December, accounting for almost half of the increase in the all items less food and energy index. The index for airline fares also continued to rise, increasing 2.4 percent in December after advancing 3.8 percent in November. Also increasing were the apparel index, which rose 0.4 percent, and the medical care index, which rose 0.1 percent. The shelter index, which declined 0.2 percent in November, was unchanged in December. The indexes for rent and owners' equivalent rent were both unchanged after declining in November, while the index for lodging away from home rose 0.5 percent in December. The index for new vehicles declined in December, falling 0.3 percent after increasing in each of the previous three months. The recreation index also declined in December, falling 0.4 percent as televisions, sporting goods and

Figure 2 shows the monthly changes in the seasonally adjusted CPI-U from 2002 to December 2009.  Note the volatility over time. The key factor in these changes has been energy prices - primarily crude oil - which dropped from a high of over $145 per barrel in July of 2008 to a recent low of about $32 per barrel in December of 2008. By the end of 2009, the price has fluctuated between $70 and $80 per barrel.

 

Figure 2 CPI

 

Measuring Consumer Prices

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. This 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. This 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.

How is the CPI 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, $20, and $30. The typical consumer purchased ten of each good. Total cost of this "market basket" in the base year was $600.

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.

[Note to teachers: For more information on the Bureau of Labor Statistics, visit the BLS Home Page .]

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.

The 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 teachers: 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 About the Council for Economic Education .

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" really 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.

[Note to teachers: Click here for more details about Measuring the CPI . Click here for BLS answers to Frequently Asked Questions About the CPI .]

Other BLS Price Indexes

The Bureau of Labor Statistics publishes several other price indexes which can be used by consumers, government agencies and, private companies for budgeting and planning.

  • Producer Price Indexes The Producer Price Indexes (PPIs) are a family of indexes that measure changes in the selling prices received by domestic producers of goods and services. They formerly were referred to as Wholesale Price Indexes. When the PPIs are released, the news media will most often report the percentage change in the index for Finished Goods. Producer Price Indexes also can be used in escalation contracts. A fact sheet named Escalation Guide for Contracting Parties further explaining the PPI details is available.
  • Import and Export Prices The International Price Program measures change in the prices of imports and exports of nonmilitary goods between the United States and the rest of the world.
  • Employment Cost Trends This program publishes quarterly statistics that measure change in labor costs (also called employment costs or compensation costs) over time; quarterly data measuring the level of costs per hour worked are also published. Indexes are available for total labor costs, and separately for wages and salaries and for benefit costs. Some information is available by region, major industry group, major occupational group, and bargaining status.
  • Contract Escalation Consumer Price Indexes, Producer Price Indexes, and the Employment Cost Index may be used to escalate contracts.
  • Consumer Price Indexes (CPIs) Consumer Price Indexes as published by individual countries, unadjusted for comparability, as well as harmonized indexes for a smaller selection of countries, are available on the International Labor ComparisonsTables page.

Deflation and Disinflation

In late 2008, after several months of decreases in the price level, many economists and planners suggested that we faced a period of "deflation." Deflation is a sustained decrease in the general price level (CPI-U) resulting in an increase in the real value (purchasing power) of money. The key to the term deflation is that it is “sustained” or occurs over a significant period of time. The changes in the price level over the past several months have been erratic, primarily due to fluctuations in food and energy prices. While food and energy have increased and decreased overt he last year, other prices have increased slightly – up only 0.1 percent in December after an increase of 0.4 percent in November.

Perhaps, a more appropriate term to describe the recent price level trend is disinflation. Disinflation is used to describe a decrease in the rate of inflation. Disinflation can occur as a natural result of the downward business cycle, reflecting decreased demand for productive resources and goods and services. If the decrease is sustained, the effect is deflation.

The differences between deflation and disinflation are primarily time and consistency - the price level change from month to month versus the price level change over a year. Another key is the role of the more volatile food and energy prices. Factoring out food and energy, the so-called core rate of inflation, prices have tended to increase at a slower rate over time. The recent announcement is a good example of this distinction.

ASSESSMENT ACTIVITY


Short Answer Essay Questions:

1. What is the different between demand-pull and cost-push inflation?

[Demand pull inflation results from increased demand for goods and services. Cost push inflation results from rising prices for productive resources. If commodity prices force producers to raise the prices of consumer products, that is an example of 'cost push.' If population increase and other factors result in a greater number of people wanting a product, it may be an example of 'demand pull.']

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. Explain how a borrower can actually 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 $11 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.]

CONCLUSION

“On a seasonally adjusted basis, the December Consumer Price Index for All Urban Consumers (CPI-U) rose 0.1 percent, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the index increased 2.7 percent before seasonal adjustment.”

Although prices rose very slightly in December, the increase in the CPI-U for the year 2009 was enough to result in a decrease in real incomes, as income increases did not keep pace with inflation.

The Federal Reserve, charged with maintaining the the purchasing power of the dollar has traditionally seen inflation as the economy's number one enemy.  During the 2008-2009 recession, low interest rates - stimulatory policies - have been implemented to encourage economic growth.  These policies have been maintained with constant attention to signs of inflation. Unfortunately, even extremely low interest rates have not created inflationary pressures - a possible result of growth. 

That's the good news and the bad news.

EXTENSION ACTIVITY

Critics of the CPI argue that the current measurement process of the CPI-U has flaws that affect the meaning of the numbers and their impact on consumers. The CPU-U measures only urban consumer prices. The CPI-U does not adequately account for changes in spending patterns over time, substitutions and quality changes. Is CPI an accurate assessment of the cost of living? 

An article in the August 2008 "Monthly Labor Review," addresses "Common Misconceptions about the Consumer Price Index: Questions and Answers." The BLS web page has a summary of the article. Students can read the summary and discuss whether or not the CPI is a meaningful measurement of cost of living.