Download Inflation October 18

A CASE STUDY
THE INFLATION RATE
Date of Announcement
February 20, 2004
Date of Next Announcement
March 19, 2004
Announcement
The consumer price index (CPI) during the month of January increased by .5 percent
(one-half of one percent). The rate of increase in the consumer price index over the past
twelve months has been 1.9 percent.
In January, the core consumer price index, which excludes energy and food prices, in
creased by 0.2 percent. The core index has increased by 1.1 percent over the last twelve
months.
Interactive question –
Compared to the history of inflation in the U.S., 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
Answer for teachers. Current inflation, at least the rate over the last 12 months, is
lower than what it was through out much of the 1970s and 1980s. However for the last
decade inflation has been at about the current rate. See table 1.
Table 1
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.
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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 fixed set
of goods relative to the cost of those same goods in a previous year. Changes in the
prices of those goods approximate changes in the overall level of prices paid by
consumers.
Data Trends
In January, the Consumer Price Index increased by .5 percent, after increasing .2
percent in December and falling by -.2 percent in November. In January, increases in
transportation costs and housing costs were largely responsible for the overall decrease.
In fact, increases in prices of energy accounted for almost three-quarters of the increase.
The prices of medical care also increased during the month.
The .5 percent increase is the most rapid monthly increase in prices in almost one
year. However the increase over the last 12 months remains rather mild.
The core rate of inflation (.2 percent in January) 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 January increase compares to a 0.1 percent increase
in the core rate of inflation in December and no change in November. Core prices
increased more slowly than the overall index due to the importance of the rapid rise in
prices of energy.
Figure 1
2
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.
Figure 2 shows what happens to those numbers when averages over three month
periods are reported instead of the inflation rates for a single month. Inflation
Figure 2
increased in 1999 and 2000 when compared to1998, fell throughout much of 2001, and
then has increased in 2002. What is really quite obvious from Figure 2 is that the
changes in inflation from month to month, even reporting the three-month averages, are
much more dramatic from 2001 on, when compared to 1998, 1999, and 2000. The
increased volatility is primarily due to fluctuations in the prices of oil and food. The
core rate of inflation (excluding food and energy) gives a much better idea of longerterm trends and that is why it is often featured in news reports. See figure 3.
Figure 3
Compared to the rates of inflation in the 1970s and much of the 1980s, the current
rate of inflation is quite low. See figure 4 below. 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.
Figure 4
The Consumer Price Index
The seasonally adjusted consumer price index in January was 185.8. 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 January 2004 by 85.8 percent.
Inflation is usually reported in newspapers and television news as percentage
changes in the CPI on a monthly basis. For example, the CPI in January was 185.8,
compared to 184.9 in December. The increase in prices from December to January was
(185.8-184.9) / 184.9 = 0.0049 or a monthly inflation rate of .49 percent. It is reported
to the nearest one-tenth of a percent, in this case, .5 percent. To convert this into an
annual rate, you could simply multiply by 12. This approximates an annual inflation
rate of (.5) (12) = 6.0 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 give the same result.
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Month
January
December
Price Level
185.8
184.9
Monthly Inflation Rate
185.8 – 184.9 = .0049 or .5 %
184.9
Annual Inflation Rate
1.004912 = 1.06 or 6 %
Deflation
Deflation is a fall in prices. Most observers would describe the current rate of
change in prices as practically no inflation or, at least, such a low rate of inflation that it
is not a serious problem. With inflation so low, it is not surprising to experience a
negative rate of inflation (or deflation) in some months. October and November of 2003
were recent months were the CPI actually declined.
If prices were to fall on a continual basis, it is not as good news as one might
initially think. If consumers expect prices to fall, many may put off purchases until
prices are lower. This decrease in overall demand may contribute to further downward
pressure on prices and to further reductions in spending. It is certainly possible, but not
likely under current conditions, to experience such an event in the U.S.
How the CPI Data are Collected.
"The Consumer Price Index (CPI) is a measure of the average change in prices over
time of goods and services purchased by households. The CPI is based on prices of food,
clothing, shelter, and fuels, transportation, fares, charges for doctors' and dentists'
services, drugs, and other goods and services that people buy for day-to-day living.
“Prices are collected in 87 urban areas across the country from about 50,000 housing
units and approximately 23,000 retail establishments - department stores, supermarkets,
hospitals, filling stations, and other types of stores and service establishments. All taxes
directly associated with the purchase and use of items are included in the index. Prices
of fuels and a few other items are obtained every month in all 87 locations.
“Prices of most other commodities and services are collected every month in the
three largest geographic areas and every other month in other areas. Prices of most
goods and services are obtained by personal visits or telephone calls of the Bureau's
trained representatives.” For more information on the Bureau of Labor Statistics, visit
(www.bls.gov).
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.
CPI interactive exercise.
Suppose a soft drink costs $1.00 at a nearby store. If the price index in 185.8 now,
approximately how much did a soft drink cost in 1983 if its price changed at the same
rate as all other prices?
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$.54
$.85
$1.00
$1.85
Teachers - The correct answer is $.54. The way to calculate is to 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 / 1.859 = $.54. A
price increase of almost 86 percent would mean a rise from $.54 to $1.00.
Prices have almost doubled.
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.
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.
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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?
Increase in
supply
Increase in
demand
Decrease
in supply
Decrease
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.
In addition, decreases in supply in most markets will cause most prices to rise. So if
costs of manufacturing rises 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 more slowly than capacity to
produce, unemployment will be rising and there will be little demand-pull inflation. If
spending is rising faster than capacity, unemployment is likely to be falling and demandpull inflation increasing.
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. Thus the index is a measure that is broader than the consumer price
index.
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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 7
percent, what has happened to real income?
a.
b.
c.
d.
3 percent
4 percent
7 percent
10 percent
2. If GDP increases by 3 percent over a year and the GDP price index increases by 2
percent, what has happened to real GDP?
a.
b.
c.
d.
1 percent
2 percent
3 percent
5 percent
3. The consumer price index has increased from 100 to 110 and average incomes have
gone from $30,000 to $36,000, what has happened to real income?
a.
b.
c.
d.
increased
decreased
not changed
cannot tell
4. 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 income?
a.
b.
c.
d.
increased
decreased
not changed
cannot tell
Answers.
1. The correct answer is ‘b’. If income has increased by seven percent and prices have
increased by three percent, the difference is the increase in real income. Thus, real
incomes have increased by four percent.
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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 ‘a’. Average income has increased by 20 percent. Prices have
increased by 10 percent [(110 – 100) / 100]. Thus real income must have increased by
approximately 10 percent.
4. The correct answer is ‘a’. Average income has increased by 20 percent. Prices have
increased by 10 percent [(275 – 250) / 250]. Thus real income must have increased by
approximately 10 percent.
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, 2002 (with a base
period of December, 2002)?
b. What is the price index for
December, 2003 (with a base
period of December, 2002)?
c. What is the rate of inflation over
the year?
Item
DVDs
Hamburgers
Socks
New clothing
December, 2002
Quantity
Price
2
5
5
1 complete set
$ 17
$3
$4
$ 50
December, 2003
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.
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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.
1. A continual increase in the average price level. The important points are that
most prices or average prices rise and that the increase continues and is not just
a one-time increase.
2. a. The price index for December, 2002 is equal to 100. The quantities for 2002
are multiplied by the 2002 prices. Then the quantities for 2002 are multiplied by
the 2003 prices. To calculate the December, 2002 price index with a base period
of that month, the 2002 quantities multiplied by the 2002 prices are divided by
the 2002 quantities multiplied by the 2002 prices and then the result is multiplied
by 100.
b. The price index for December, 2003 is equal to 109.7. To calculate the
December, 2003 price index with a base period of December, 2002, the 2002
quantities multiplied by the 2003 prices are divided by the 2002 quantities
multiplied by the 2002 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.
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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.
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
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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
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
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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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