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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 1 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? 2 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. 3 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? 4 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. 5 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 6 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. 7 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. 8 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. 9 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 10 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 11