Download Inflation October 18

A CASE STUDY
THE INFLATION RATE
Date of Announcement
April 20, 2005
Date of Next Announcement
May 18, 2005
Announcement
The consumer price index (CPI) during the month of March increased by .6 percent
(six-tenths of one percent). The rate of increase in the consumer price index over the
past twelve months has been 3.1 percent.
In March, the core consumer price index, which excludes energy and food prices,
increased by 0.4 percent. The core index has increased by 2.3 percent over the last
twelve months.
Interactive question –
Compared to the last several months, is this rate of inflation particularly high, low,
or just about equal to previous levels?
Current
inflation is
higher
Current
inflation is
about the same
Current
inflation is
lower
Pop-up answer –
Current
inflation is
higher
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Answer for teachers. Inflation is higher this month then during the previous four
months. See figure 1.
Figure 1
Information for Teachers
All paragraphs in italics will not appear in the student version of the inflation case
study. The original press release can be found at www.bls.gov/news.release/cpi.nr0.
htm.
Goals of Case Study
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 set of
goods and services relative to the cost 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.
Data Trends
In March, the Consumer Price Index increased by .6 percent, after increasing .4
percent in February and increasing by .1 percent in January. In March, increases in
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transportation costs and apparel were largely responsible for the overall increase.
Increases in prices of energy accounted for almost half of the increase. The prices of
housing and medical care also increased during the month.
The .6 percent increase is the most rapid monthly increase in prices since last
October. The annual rate of increase over the last three month was 3.1 percent and over
the last 12 months, 4.3 percent. Annual inflation rates during all of 2002, 2003, and
2004 were 1.6, 2.3 and 2.7 percent.
The core rate of inflation (.4 percent in March) 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 March increase compares to a .3 percent increase in
the core rate of inflation in February and .2 percent in January. Core prices increased
more slowly in those months than the overall index due to the rapid rises in prices of
energy.
Extra attention is given by forecasters to the core index as it tends to show more
lasting trends in prices.
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, the
trend has been an increasing trend over the last four months.
Figure 2 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. Even though recent rates have increased
slightly, the U.S. economy is experiencing inflation that is significantly below what is
possible.
Figure 2
The Consumer Price Index
The seasonally adjusted consumer price index in March was 193.2. The price index
was equal to 100 during the period from 1982 to 1984. The interpretation is that prices
in the market basket of goods and services purchased by the typical consumer increased
from the 1982-1984 period to March 2004 by 93.2 percent. A typical consumer good
that cost one dollar in 1983 now costs $1.93.
Inflation is usually reported in newspapers and television news as percentage
changes in the CPI on a monthly basis. For example, the CPI in March was 193.2,
compared to 192.0 in February. The increase in prices from February to March was
(193.2 – 192.0) / 192.0 = 0.00625 or a monthly inflation rate of .625 percent. It is
reported to the nearest one-tenth of a percent, in this case, .6 percent. To convert this
into an annual rate, you could simply multiply by 12. This approximates an annual
inflation rate of (.6) (12) = 7.2 percent. A slightly more accurate measurement of the
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annual inflation rate is to compound the monthly rate, or raise the monthly rate of
increase, plus one, to the 12th power. The result is an annual rate of inflation of 7.8
percent.
Table 1
Month
March
February
Price Level
193.2
192
Monthly Inflation Rate
193.2 – 192 = .00625 or .6 %
192
Annual Inflation Rate
1.0062512 = 1.078 or 7.8 %
How the CPI is Calculated
Assume that there are only two goods included in the typical consumer’s purchases
and, in the base or original year, each goods costs $10.00. Each consumer purchases
one of each good.
In the current year, the goods cost $11 and $12. The index for the current year
would be the quantities purchased in the market basket (one each of each good) times
their prices in the current year divided by the quantities purchased in the market basket
times their prices in the base year.
Thus ( 1 x $11 + 1 x $12 ) / ( 1 x $10 + 1 x $10 ) = $23 / $20 = 1.15. That is, prices
in the current year are 1.15 times those prices in the original year. Prices have increased
on average by 15 percent. That is true. The price of one good increased by 10 percent.
The price of the second good increased by 20 percent. By convention, the indexes are
multiplied by 100 and reported as 115 instead of 1.15.
The base year index simply divides the prices in the base year by the prices in base
year. The index then is 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,
transportation, medical, dental, and legal services and hundreds of 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.
Almost 100 urban areas are sampled by Bureau of Labor Statistics professionals
including visits and phone calls to 50,000 households and almost 25,000 retail stores and
offices.
For more information on the Bureau of Labor Statistics, visit www.bls.gov.
CPI interactive exercise.
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Suppose a soft drink costs $1.00 at a nearby store. If the price index in 185.8 now,
approximately how much did a soft drink cost in 1983 if its price changed at the same
rate as all other prices?
$.52
$.93
$1.00
$1.93
Pop-up -
$.52
Teachers - The correct answer is $ .52. To calculate, divide the current price by
the current index with the decimal placed after the first digit. (Remember that
we multiplied the index by 100.) Thus, $1.00 / 1 .93 = $.52. A price increase of
93 percent would mean a rise from $.52 to $1.00. Prices have almost doubled.
Causes of Inflation
To understand causes of inflation, think of individual markets. What might cause prices
to increase if we observe that prices are rising in most markets? Choose as many as are
relevant.
Increases
in supply
Pop-up –
Decreases
in supply
Increases
in demand
Decreases
in supply
Decreases
in demand
Increases
in demand
The correct answers - Increases in demand will cause prices to rise. If demand
is rising more rapidly than supply in most markets, most prices will be rising.
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In addition, decreases in supply in most markets will cause most prices to rise.
So if costs of manufacturing rise rapidly, prices in most markets will rise.
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.
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. 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 facing consumers. 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.
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Self-tests for understanding data.
1. If inflation is 3 percent a year and average income increases by 5 percent, what has
happened to real average income?
a.
b.
c.
d.
e.
Decreased by 2 percent
Increased by 2 percent
Increased by 3 percent
Increased by 5 percent
Increased by 8 percent
2. If GDP increases by 3 percent over a year and the GDP price index increases by 4
percent, what has happened to real GDP?
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
3. Suppose the CPI was 150 for March of one year, and was 170 for March of the next
year. What is the approximate annual rate of inflation?
a.
b.
c.
d.
e.
70 percent
20 percent
17 percent
15 percent
13 percent
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?
a.
b.
c.
d.
Increased by 60 percent
Increased by 80 percent
Increased by 100 percent
Increased by 160 percent
5. The consumer price index has increased from 100 to 110 and average incomes have
gone from $30,000 to $33,000, what has happened to real income?
a.
b.
c.
d.
increased
decreased
not changed
One cannot tell.
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6. If the consumer price index has increased from 250 to 275 and average income has
gone from $30,000 to $36,000, what has happened to real average income?
a.
b.
c.
d.
increased
decreased
not changed
One cannot tell.
7. Create a price index for two years given the following data.
The first year – consumers purchase 5 CDs each at a price of $15 and 10 candy
bars each at a price of $1.
The second year – consumers purchase 7 CDs each at a price of $14 and 8 candy
bars each at a price of $2.
Answers.
1. The correct answer is ‘b’. If income has increased by five percent and prices
have increased by three percent, the difference is the increase in real income.
Thus, real incomes have increased by two percent.
2. The correct answer is ‘a’. GDP in current prices has increased by one percent
more than the change in the price level. Thus real GDP must have increased by
one percent.
3. The correct answer is ‘e’. The rate of increase in prices over the year can be
calculated by dividing the increase in the index by the initial level of the index.
That is (170 - 150) / 150 = .133 or 13.3 percent. Because this is over a twelvemonth period, it is an annual rate of inflation. Single month changes are slightly
more complicated to convert to annual results.
4. The correct answer is ‘c’. 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. The correct answer is ‘c’. Average income has increased by 10 percent. Prices
have increased by 10 percent [(110 – 100) / 100]. Thus real income must have
increased by approximately 10 percent.
6. The correct answer is ‘a’. Average income has increased by 20 percent. Prices
have increased by 10 percent [(275 – 250) / 250]. Thus real average income
must have increased by approximately 10 percent.
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7. Students should use the base year quantities. One could calculate the result by
using either year as the base year. We use the first year. The index for the base
year would be one (times 100). That is, prices in the first year are 100 percent of
the prices in the first year.
The index for the second year is calculated as follows.
Quantities in the base year times prices in the current year
Quantities in the base year times prices in the base year
=
(5 x $14) + (10 x $2) = $90 = 1.059
(5 x $15) + (10 x $1)
$85
To calculate the index we multiply the result by 100. The index for the second
year is 105.9. That is inflation has been 5.9 percent.
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.
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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
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
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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
Vanderbilt University
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