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A CASE STUDY
THE INFLATION RATE
August, 2006
Date of Announcement
September 15, 2006
Date of Next Announcement
October 18, 2006
Announcement
The consumer price index (CPI) during the month of August increased by .2 percent (twotenths of one percent). The rate of increase in the consumer price index over the past
twelve months has been 3.8 percent.
In August, the core consumer price index, which excludes energy and food prices, also
increased by .2 percent (two-tenths of one percent). The core index has increased by 2.8
percent over the last twelve months.
Interactive question –
Given the difference in the changes in the consumer price index and the core index over
the last 12 months, what must be happening to energy or food prices?
Energy or food
prices must be
increasing
Energy or food
prices could be
increasing or
decreasing
Energy or food
prices must be
decreasing
Pop-up answer –
Energy or food
prices must be
increasing
If one of the other answers is chosen, this should pop-up –
No, that is not
correct. Think
about the meaning
of the indexes and
try again.
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Answer for teachers. The answer is that the CPI has increased by 3.8 percent and the core by
2.8 percent over the last 12 months. The core index excludes changes in food and energy
prices. Thus, the only change that can cause the more rapid increase in the overall index is a
faster increase in food and energy prices. Food and energy prices together must have
increased by more than the prices of all other goods.
Energy prices have been the real cause – a very large increase of 15.1 percent over the last 12
months. (Food prices increased by 2.4 percent.)
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 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.
The core consumer price index is the average price of the same set of goods and services,
without including food and energy prices, relative to the price of the same goods and services
without food and energy prices in a previous month or year.
Data Trends
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In August, the consumer price index increased by .2 percent, after increasing .4 percent in
July. In August, energy prices increased, but at a sharply slower rate.
The annual rate of change over the last three months was 3.6 percent and over the last 12
months, an increase of 3.8 percent. Annual inflation rates during all of 2002, 2003, and 2004
were 2.4, 1.9 and 3.3 percent.
Recent news stories have focused on the rapid increases in energy prices followed by
reduction in part of the last year. Still the increases in the overall CPI and the core index
have been more rapid than the previous three years.
The core rate of inflation (increased by .2 percent in August) represents changes in 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 increased August index compares to a
.2 percent increase in the core rate of inflation in July and .3 percent in each of the previous
four months. Extra attention is given by forecasters to the core index as it tends to show
more lasting trends in prices. This month’s results provide some evidence that the increase in
energy prices over the last several years has not significantly influenced rates of increases in
all other prices. Still the rapid rise in energy prices may eventually have a significant effect
on all other prices in the economy.
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 few months. It is however difficult to tell
what the trend over a longer period of time has been.
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, prior to this month, as high and they are not,
when compared to those of the past thirty years. However, the recent rates have been
increasing and that has caused some concern. See the most recent Federal Reserve case study
and the exercises at the end of this case.
Figure 2
The Consumer Price Index
The seasonally adjusted consumer price index in August was 203.7. The price index was equal
to 100 during the period from 1982 to 1984. The appropriate interpretation of the index is
that prices in the market basket of goods and services purchased by the typical consumer
increased from the 1982-1984 period to August 2006 by 103.7 percent. A typical consumer
good that cost one dollar in 1983 now costs almost $2.04.
Inflation is announced and reported in newspapers and television news as percentage changes
in the CPI on a monthly basis. For example, the CPI in August was 203.7, compared to 203.2
in July. The increase in prices from July to August was (203.7 – 203.2) / 203.2 = .002. That
means a monthly inflation rate of .2 percent.
To convert this into an approximate annual rate, you can simply multiply by 12. This provides
us an annual deflation rate of (.2) (12) = 2.4 percent.
Table 1
Month
August
July
Price Level
203.7
203.2
Monthly Inflation Rate
203.7 – 203.2 = .002 or .2 %
203.2
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How the CPI is 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 $10.00, $20.00, and $30.00. The typical
consumer purchased ten of each good.
In the current year, the goods’ prices are $11, $24, and $33. Consumers now purchase 12,
8, and 11 of each good.
The CPI for the current year would be 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.
For more information on the Bureau of Labor Statistics, visit www.bls.gov.
A Market Basket of Goods and Services
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.
The relative importance of each of the categories of goods and services that included in the
market basket are as follows.
Housing
Transportation
Food and beverages
Medical care
42 %
17 %
15 %
6%
Recreation
Education and communication
Clothing
Other goods and services
6
6
4
4
%
%
%
%
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CPI Interactive Exercise
If a family’s annual income has increased from $20,000 to $45,000 over the last 22 years
(from 1983 to 2005), what has happened to its real income? Its real income has:
Increased
Decreased
Not
changed
One cannot
tell.
Pop-up -
Increased
If one of the other answers is chosen, this should pop-up –
No, that is not correct. Think
about the current index and
compare the change to the
change in nominal income.
Then, try again.
Teachers - The correct answer is increased. There are two primary ways to make the
calculation. Prices have almost doubled. Income has more than doubled. Thus, real income
has increased as prices have increased by less than nominal (using current prices) income.
A second method is that one could divide the current nominal income by 1.977 to get the
current income in 1983 dollars. That is the real income. The result is that the current real
income is $22,762. Thus real income has increased from $20,000 to $22,762.
CPI Interactive Exercise
If GDP in a country increases from $10 trillion to $11 trillion from one year to the next,
what has happened to real GDP? The GDP price index was 200 in the first year and 210 in the
second.
Increased
Decreased
Not
changed
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Pop-up -
Yes, that is correct.
Real GDP increased.
If one of the other answers is chosen, this should pop-up –
No, that is not correct.
Compare the percentage
increase in GDP with the
percentage increase in prices.
Then, try again.
Teachers - The correct answer is increased. Again there are two ways to arrive at the
answer. Prices increased by 5 percent. GDP increased by 10 percent. Therefore, real GDP
increased by 5 percent.
A more exact calculation is to calculate real GDP in both cases. In the first year, real
GDP equals $10 trillion / 2.00 = $5 trillion in the base year’s dollars. In the second year, real
GDP equals $11 trillion / 2.1 = $5.24 trillion.
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.
Questions
1. If the annual rate of inflation is 4 percent a year and average income increases by 3
percent, what has happened to real average income?
a.
b.
c.
d.
e.
Decreased by 1 percent
Decreased by 3 percent
Increased by 1 percent
Increased by 3 percent
Increased by 7 percent
2. Suppose the CPI was 100 one year, and was 105 the next year. What is the approximate
annual rate of inflation for those 12 months?
a.
b.
c.
d.
5 percent
10 percent
10.5 percent
105 percent
3. Suppose the CPI was 200 in one year and 220 in the next year. What was the annual rate
of inflation for those 12 months?
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a.
5 percent
b. 10 percent
c. 20 percent
d. 120 percent
e. 220 percent
4. Suppose a bicycle cost $200 in 1983 and a similar new bicycle costs $500? Given what you
know about current price indexes, has the real cost of the bicycle increased or decreased?
a.
b.
c.
d.
increased
decreased
stayed the same
one cannot tell.
5. An automobile costs $15,000 in 1983. It costs $35,000 this year. What has happened to
the price in 1983 dollars?
a.
b.
c.
d.
increased
decreased
stayed the same
one cannot tell.
Answers to questions.
1. The correct answer is ‘a’. If income has increased by three percent and prices have
increased by four percent, real incomes have had to decrease. An approximation is
that real incomes have decreased by one percent.
2. The correct answer is ‘a’. 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 (105 - 100) / 100 = .05 or 5 percent. That is an increase of 5 is 5 percent of a
starting year index of 100. Because this is over a twelve-month period, it is an
annual rate of inflation.
3. The correct answer is ‘b’. Prices have increased 10 percent. The change in the
index is 20. The initial year is 200. Thus the annual inflation is 20 / 200 or 10
percent.
4. The correct answer is ‘a’. Prices have approximately doubled. The price of the
bicycle has more than doubled. Thus, the real cost of the bicycle, the price in 1983
dollars, has increased.
5. The correct answer is ‘d’. Average prices have approximately doubled. The price of
the automobile has more than doubled. Thus the price, in 1983 dollars, has
increased. However, if the quality has increased than the automobile is not the same
product and comparisons of prices are much more difficult. It may be that the
automobile’s price in 1983 dollars has actually decreased once we adjust for the
improvement in quality.
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Key Concepts
Inflation
Consumer price index (CPI)
Unemployment
Real income
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 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
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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
Vanderbilt University
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