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A CASE STUDY
THE OCTOBER INFLATION RATE
Date of Announcement
November 16, 2005
Date of Next Announcement
December 15, 2005
Announcement
The consumer price index (CPI) during the month of October increased by .2 percent
(two-tenths of one percent). The rate of increase in the consumer price index over the past
twelve months has been 4.3 percent.
In October, the core consumer price index, which excludes energy and food prices,
also increased by 0.2 percent. The core index has increased by 2.1 percent over the last
twelve months.
Interactive question –
Compared to inflation in the U.S. since 2000, is the rate of inflation over that last
twelve months particularly high, low, or just about equal to previous levels?
Current
inflation is
higher
Current
inflation is
about the same
Current
inflation is
lower
Answer for teachers. Current inflation, at least the rate over the last 12 months, is higher
than what it was since 2000.
Information for Teachers
All paragraphs in italics will not appear in the student version of the inflation case
study. This case builds upon the previous inflation case study. More advanced concepts
and questions will be added throughout the fall semester.
The original press release can be found at www.bls.gov/news.release/cpi.nr0.htm.
Goals of Case Study
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The goals of the inflation case studies are to provide teachers and students:
access to easily understood, timely interpretations of monthly announcements of
rate of change in prices in the U.S. economy;
descriptions of major issues surrounding the data announcements;
brief analyses of historical perspectives;
questions and activities to use to reinforce and develop understanding of relevant
concepts; and
a list of publications and resources that may benefit classroom teachers and
students interested in exploring inflation.
Definitions of Inflation
Inflation is a continual increase in the overall level of prices. It is an increase in
average prices that lasts at least a few months. The most widely reported measurement of
inflation is the consumer price index (CPI). The CPI measures the cost of a fixed set of
goods relative to the cost of those same goods in a previous month or year. Changes in
the prices of those goods approximate changes in the overall level of prices paid by
consumers.
Data Trends
In October, the Consumer Price Index increased by .2 percent, after increasing 1.2
percent in September and .5 percent in August. In October, housing prices increased, but
transportation and apparel prices decreased. The prices of medical care increased during
the month.
The .2 percent increase is the lowest monthly increase in prices since June.
The core rate of inflation (.2 percent) represents the consumer price index without the
influences of changes in the prices of food and energy, which can fluctuate widely from
month to month. The October increase compares to a 0.1 percent increase in the core rate
of inflation in each month since April when it did not change.
Interactive exercise:
Compare the annual rates of change in the last 12 months for all prices and the core
index. What does that comparison say about the relation of increase in all prices and the
increase in energy and food prices?
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Energy and
food prices
increased
more rapidly
than all other
prices.
Energy and
food prices
increased
more slowly
than all other
prices.
Energy and
food prices
increased at
about the same
rate as all other
prices.
Responses:
To “increased more rapidly”: Yes, this is correct. Core prices increased more slowly
than the overall index due to the importance of the rapid rise in prices of energy.
To “increased more slowly”: No, this is incorrect. Core prices increased more slowly
than the overall index due to the importance of the rapid rise in prices of energy.
To “increased at about the same rate”: No, this is incorrect. Core prices increased
more slowly than the overall index due to the importance of the rapid rise in
prices of energy.
Figure 1 shows recent inflation data reported for each month. It is obvious that the
monthly inflation figures change a great deal and that rates of inflation are not exactly
stable from one month to the next. The rates appear to vary more beginning in 2003
through 2005.
Figure 1
Figure 2 adds the core index in a dashed, red line. The core index does not vary as
much as the CPI as oil and food prices have been particularly volatile in the last three
years. The core rate of inflation (excluding food and energy) gives a much better idea of
longer-term trends and that is why it is often featured in news reports.
Figure 2
Compared to the rates of inflation in the 1970s and much of the 1980s, the current
rate of inflation is quite low. See figure 3 for annual rates of inflation throughout that
entire period. Few observers would describe the most recent rates as high and they are
not, when compared to those of the past thirty years. Other observers would describe the
current experience as no or zero inflation.
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The Consumer Price Index
The seasonally adjusted consumer price index in October was 198.9. The price index
was equal to 100 during the period from 1982 to 1984. The interpretation is that prices in
market basket of goods purchased by the typical consumer increased from the 1982-1984
period to October 2004 by almost 100 percent. That is they have almost doubled.
Inflation is usually reported in newspapers and television news as percentage changes
in the CPI on a monthly basis. For example, the CPI in October was 198.9, compared to
198.5 in September. The increase in prices from September to October was (198.9198.5) / 198.5 = 0.0020 or a monthly inflation rate of .2 percent. To convert this into an
annual rate, you could simply multiply by 12. This approximates an annual inflation rate
of (.2) (12) = 2.4 percent. A slightly more accurate measurement of the annual inflation
rate is to compound the monthly rate, or raise the monthly rate of increase, plus one, to
the 12th power, which in this case gives the same result when rounded off.
Month
October
September
Price Level
198.9
198.5
Monthly Inflation Rate
198.9 – 198.5 = .0020 or .2 %
198.5
Annual Inflation Rate
1.002012 = 1.0243 or 2.4 %
How the CPI Data are Collected.
The CPI is based on prices of food, clothing, housing, transportation, and all the other
goods and services that people purchase on a regular basis. Forty percent of those prices
are prices of goods; sixty percent are prices of services.
Prices are collected through phone interviews and visits in almost 90 cities around the
country. Almost 25,000 grocery stores, clothing stores, service stations, hospitals, and
other retail stores are included. Fifty thousand families are interviewed.
For more information on the Bureau of Labor Statistics, visit (www.bls.gov).
CPI interactive exercise.
Assume a family’s income has increased from $40,000 to $44,000 during one year. If the
CPI has increased from 150 to 160, than what has happened to their real income? Or
another way of asking the same question, what has happened to their abilities to purchase
goods and services?
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Increased
by 10%
Increased
by less
than 10 %
Decreased
by 10 %
Decreased
by less
than 10 %
If “increased by less than 10%” is chosen:
Yes, that is correct. Income has increase 10 percent. Prices have
increase by 6.67percent. Thus, real income has increased by about 3.33
percent.
If one of the other options is
chosen:
No, that is incorrect. Think about the percentage increase in income and
compare that to the percentage increase in prices. Try once again.
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.
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4. Inflation does reduce the purchasing power of money.
5. Inflation does redistribute income. On average, individuals' incomes do increase
as inflation increases. However, some peoples’ wages go up faster than inflation. Other
wages are slower to adjust. People on fixed incomes such as pensions or whose salaries
are slow to adjust are negatively affected by unexpected inflation.
Other Measures of Inflation
The GDP price index (sometimes referred to as the implicit price deflator). The GDP
price index is an index of prices of all goods and services included in the gross domestic
product. Thus the index is a measure that is broader than the consumer price index.
The producer price index. This index measures prices at the wholesale or producer
level. It can act as a leading indicator of inflation. If the prices producers are charging
are increasing, it is likely that consumers will eventually be faced with higher prices for
good they buy at retail stores.
Self-tests for understanding data.
1. If inflation increases by 3 percent over a year and average income increases by 4
percent, what has happened to real income?
a.
b.
c.
d.
e.
Decreased by 1 percent
Increased by 1 percent
Increased by 3 percent
Increased by 4 percent
Increased by 7 percent
2. If GDP increases by 3 percent in a year and the GDP price index increases by 5
percent, what has happened to real GDP during that year?
a.
b.
c.
d.
e.
Decreased by 2 percent
Decreased by 3 percent
Increased by 2 percent
Increased by 3 percent
Increased by 5 percent
3. The consumer price index has increased from 200 to 220 and average incomes have
gone from $30,000 to $36,000, what has happened to real income?
a. increased
b. decreased
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c. not changed
d. cannot tell
4. A movie ticket cost $5.00 in 1983. If the consumer price index equaled 100 in 1983
and 200 in 2005, what is the price, in 2006 dollars, of a movie ticket purchased in 1983?
a.
b.
c.
d.
$2.50
$5.00
$7.50
$10.00
Answers.
1. The correct answer is ‘c’. If income has increased by four percent and prices have
increased by three percent, the difference is the increase in real income. Thus, real
incomes have increased by one percent.
2. The correct answer is ‘a’. GDP in current prices has increased by three percent.
Prices have increase by five percent. Real output of goods and services must have fallen.
Real GDP will have decreased by two percent.
3. The correct answer is ‘a’. Average income has increased by 20 percent. Prices have
increased by 10 percent [(220 – 200) / 200]. Thus real income must have increased by
approximately 10 percent.
4. The correct answer is ‘d’. Prices have doubled. Thus, in 2006 dollars, the price of
movie tickets would now be $10.00.
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Other questions for students
1. What is inflation?
2. Calculate price indexes for the following hypothetical secondary student’s budget.
a. What is the price index for
December, 2005 (with a base
period of December, 2004)?
b. What is the price index for
December, 2005 (with a base
period of December, 2004)?
c. What is the rate of inflation over
the year?
Item
DVDs
Hamburgers
Socks
New clothing
December, 2004
Quantity
Price
2
5
5
1 complete set
$ 17
$3
$4
$ 50
December, 2005
DVDs
Hamburgers
Socks
New clothing
3
6
4
1 complete set
$ 14
$4
$ 4.50
$ 60
3. Suppose the CPI was 150 for July of one year, and was 170 for July of the next year.
What is the corresponding annual rate of inflation?
4. The base year of the CPI is 1982-1984. What has happened to prices since 1970 if
the 1970 index was approximately 80 and if the current CPI were 160?
5. Given the following data, calculate the rate of inflation between 2001 and 2002.
CPI
1998
1999
2000
2001
2002
163.0
166.6
172.2
177.1
179.9
Average per capita
disposable income
1998
2001
$ 23,037
$ 25,957
6. Given the above data, calculate the average rate of inflation between 1998 and 2002.
7. Using the above data, calculate average real income in 1998 and 2001. Did real per
capita income increase or decrease from 1998 to 2001?
Answers to go with other questions.
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1. A continual increase in the average price level. The important points are that most
prices rise or average prices rise and that the increase continues and is not just a
one-time increase.
2. a. The price index for December, 2004 is equal to 100. The quantities for 2004
are multiplied by the 2004 prices. Then the quantities for 2004 are multiplied by
the 2005 prices. To calculate the December, 2004 price index with a base period
of that month, the 2004 quantities multiplied by the 2004 prices are divided by the
2004 quantities multiplied by the 2004 prices and then the result is multiplied by
100.
b. The price index for December, 2005 is equal to 109.7. To calculate the
December, 2005 price index with a base period of December, 2004, the 2004
quantities multiplied by the 2005 prices are divided by the 2004 quantities
multiplied by the 2005 prices and then the result is multiplied by 100.
c. The annual rate of inflation over the period is 9.7 percent. (The index for
December 2003 minus the index for December 2003, given that the first index is
the base year.)
3. The rate of increase in prices from over the year can be calculated by dividing the
increase in the index by the initial level of the index. (These indexes show a much
higher rate of inflation than the actual.)
That is (170 - 150) / 150 = .133 or 13.3 percent. Because this is over a twelvemonth period, it is an annual rate of inflation. More difficult interpretations are
based on single month changes. The results are normally converted to annual
rates of inflation.
4. A current level of 160 would mean that consumer prices on average are 100
percent higher than their 1970 levels. The percentage increase is (160 - 80) / 80
= 1 or 100 percent. The base year period is not relevant to the calculation.
5. 1.6 percent. 179.0 / 177.1 = 1.016 or an increase of 1.6 percent.
6. 2.6 percent. 179.9 / 163 = 1.104 or an increase of 10.4 percent. The annual
average increase can be approximated by dividing 10.4 percent by four (years)
and thus get 2.6 percent per year.
7. The real incomes, in 1982-1984 dollars, are calculated as follows:
Real income in 1998 = $23,037 / 1.630 = $14,133.
Real income in 2001 = $25,957 / 1.771 = $14,657.
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Yes, real income did increase, but not by almost $3,000, the difference between
the nominal incomes.
Key Concepts
Inflation
Causes
Costs
Consumer price index (CPI)
Unemployment
Monetary policy
Money
Full-employment real GDP
Relevant National Economic Standards
The relevant national economic standards are numbers 18, 19, and 20.
10. Institutions evolve in market economies to help individuals and groups
accomplish their goals. Banks, labor unions, corporations, legal systems,
and not-for-profit organizations are examples of important institutions. A
different kind of institution, clearly defined and enforced property rights,
is essential to a market economy. Students will be able to use this
knowledge to describe the roles of various economic institutions.
11. Money makes it easier to trade, borrow, save, invest, and compare the
value of goods and services. Students will be able to use this knowledge to
explain how their lives would be more difficult in a world with no money,
or in a world where money sharply lost its value.
18. A nation's overall levels of income, employment, and prices are
determined by the interaction of spending and production decisions made
by all households, firms, government agencies, and others in the economy.
Students will be able to use this knowledge to interpret media reports
about current economic conditions and explain how these conditions can
influence decisions made by consumers, producers, and government policy
makers.
19. Unemployment imposes costs on individuals and nations. Unexpected
inflation imposes costs on many people and benefits some others because
it arbitrarily redistributes purchasing power. Inflation can reduce the rate
of growth of national living standards because individuals and
organizations use resources to protect themselves against the uncertainty
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of future prices. Students will be able to use this knowledge to make
informed decisions by anticipating the consequences of inflation and
unemployment.
20. Federal government budgetary policy and the Federal Reserve
System's monetary policy influence the overall levels of employment,
output, and prices. Students will be able to use this knowledge to
anticipate the impact of federal government and Federal Reserve System
macroeconomic policy decisions on themselves and others.
Sources of Additional Activities
Advanced Placement Economics: Macroeconomics. (National Council on
Economic Education)
Measuring Economic Performance. Lesson 4. Measuring and
Understanding Inflation
Focus on Economics: High School Economics (National Council on Economic
Education)
Lesson 18. Economics Ups and Downs
Economics USA: A Resource Guide for Teachers
Lesson 9: Inflation: How Did the Spiral Begin?
High School Economics Courses: Teaching Strategies
Lesson 16: The Trial of Ms. Ann Flation
Handbook of Economic Lessons (California Council on Economic Education)
Lesson 20. Plotting the Ups and Downs of the U.S. Economy
All are available in Virtual Economics, An Interactive Center for Economic
Education (National Council on Economic Education) or directly through
the National Council on Economic Education.
Authors: Stephen Buckles
Erin Kiehna
Vanderbilt University
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