Download Inflation October 18

A CASE STUDY
THE APRIL INFLATION RATE
May 17, 2006
Date of Announcement
May 7, 2006
Date of Next Announcement
June 14, 2006
Announcement
The consumer price index (CPI) during the month of April 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 3.5 percent.
In April, the core consumer price index, which excludes energy and food
prices, increased by .3 percent (three-tenths of one percent). The core
index has increased by 2.3 percent over the last twelve months.
Interactive question –
Is the rate of inflation, as measured by changes in the overall CPI,
during April particularly high, low, or just about equal to recent monthly
levels?
Current
inflation is
higher than it
has been.
Current
inflation is
about the
same as it has
been.
Current
inflation is
lower than it
has been.
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Pop-up answer –
Current
inflation is
higher than
it has been.
If one of the other answers is chosen, this should pop-up –
No, that is not
correct. Inflation in
April was above that
of recent months.
Is the rate of inflation, as measured by the core CPI, over the last 12
months particularly high, low, or just about the same when compared to
changes over the last 25 years?
Current
inflation is
higher than
recent
years.
Pop-up answer –
Current
inflation is
about the same
as recent years.
Current
inflation is
lower than
recent years.
Current inflation is
lower than in recent
years.
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If one of the other answers is chosen, this should pop-up –
No, that is not correct.
Inflation over the last
12 months is lower than
it has historically been.
For teachers – Inflation during April appears to be increasing, but still
inflation over the last year is still low relative to past rates.
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.
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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 set without food and energy prices in a previous month or year.
Data Trends
In April, the consumer price index increased by .6 percent, after
increasing .4 percent in March and .1 percent in February. In April, energy
prices increased once again. Price indexes for transportation and apparel
also rose.
The annual rate of change over the last three months was an increase of
4.1 percent and over the last 12 months, an increase of 3.5 percent. Annual
inflation rates from 2002 through 2005 were 2.4, 1.9, 3.3 and 3.4 percent.
The core rate of inflation (increased by .3 percent in April) 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 April index compares to .1 and .3 percent increases in
the core rate of inflation in each of the previous two months. Core prices
increased more slowly in the last two months than the overall index due to
rises in prices of energy. The annual rate of increase in prices of energy
over the last three months was 16.9 percent.
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, but may
be beginning to have an upward pressure on other prices. The rapid rise in
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energy prices may eventually have a significant effect on all other prices in
the economy.
Figure 1
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 one over the
last several months. It is however difficult to tell what the trend over a
longer period of time has been.
Figure 2 shows the changes in the core index compared to the changes in
the overall CPI. Obviously the changes in prices other than energy and food
have been significantly smaller than the changes in the overall index.
Figure 2
Figure 3 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 the last few months, 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 3
The Consumer Price Index
The seasonally adjusted consumer price index in April was 201. 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
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the 1982-1984 period to April, 2006 by 101 percent. A typical consumer
good that cost one dollar in 1983 now costs $2.01.
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
April was 201, compared to 199.8 in March. The increase in prices from
April to March was (201 – 199.8) / 199.8 = .006. That means a monthly
inflation rate of .6 percent or six-tenths of one percent.
To convert this into an approximate annual rate, you can simply multiply
by 12. This provides us an annual inflation rate of (.6) (12) = 7.2 percent.
Table 1
Month
April
March
Price
Level
201
199.8
Monthly Inflation Rate
201 – 199.8 = .006 or .6 %
199.8
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.
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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
42 %
17 %
Recreation
6%
Education and communication 6 %
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Food and beverages 15 %
Medical care
6%
Clothing
Other goods and services
4%
4%
CPI Interactive Exercise
If a family’s annual income has increased from $30,000 to $40,000 over
the last 22 years (from 1983 to 2006), what has happened to its real
income? Its real income has:
Increased
Pop-up -
Decreased
Not
changed
One cannot
tell.
Decreased
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 decreased. There are two primary ways
to make the calculation. Prices have doubled. Income in this case has
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increased by one-third. Thus, real income has decreased as prices have
increased by more than nominal (using current prices) income.
A second method is that one could divide the current nominal income by
2.01 to get the current income in 1983 dollars. That is the real income.
The result is that the current real income is $19,900. Thus real income has
decreased from $30,000 to $19,000.
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? Assume that the GDP
price index was 200 in the first year and 220 in the second.
Increased
Decreased
Not
changed
Pop-up – If the third answer is chosen.
Yes, that is correct.
Real GDP has not
changed.
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.
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Teachers - The correct answer is not changed. Again there are two
ways to arrive at the answer. Prices increased by 10 percent. GDP
increased by 10 percent. Therefore, real GDP did not change.
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 / 2.20 = $5 trillion.
Below another measure, the GDP price index, is discussed and it is the one
that is actually used in relationship to GDP.
Causes of Inflation
To understand causes of inflation, think of markets for individual products.
What might cause prices to increase if we observe that prices are rising in
most markets and if we know that overall output is rising? Choose as many
as are relevant.
Increases
in supply
Pop-up –
Increases
in demand
Decreases
in supply
Decreases
in demand
Increases
in demand
Teachers - The correct answer - Increases in demand will cause
prices to rise at the same time quantity is increasing. If demand is
rising more rapidly than supply in most markets, most prices will be
rising and output will be increasing.
If the cause of inflation were decreases in supply, output would be
falling.
What might cause prices to increase if we observe that prices are rising in
most markets and if we know that overall output is falling? Choose as many
as are relevant.
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Increases
in supply
Pop-up –
Increases
in demand
Decreases
in supply
Decreases
in demand
Decreases in
supply
Teachers - The correct answer - Decreases in supply will cause prices
to rise while at the same time output is falling. If the cause of inflation
is an increase in demand, then output should be increasing.
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 fullemployment 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 costpush 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.
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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 and is more appropriate to
use in calculating real GDP than the CPI, which measures changes in
consumer prices alone.
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.
A Note on Seasonally Adjusted and Unadjusted Data
"Because price data are used for different purposes by different
groups, the Bureau of Labor Statistics publishes seasonally adjusted as well
as unadjusted changes each month. For analyzing general price trends in the
economy, seasonally adjusted changes are usually preferred since they
eliminate the effect of changes that normally occur at the same time and in
about the same magnitude every year--such as price movements resulting
from changing climatic conditions, production cycles, model changeovers,
holidays, and sales.
The unadjusted data are of primary interest to consumers concerned
about the prices they actually pay. Unadjusted data also are used
extensively for escalation purposes. Many collective bargaining contract
agreements and pension plans, for example, tie compensation changes to the
Consumer Price Index unadjusted for seasonal variation."
(ftp://146.142.4.23/pub/news.release/cpi.txt)
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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 longterm 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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Full employment
Economists define the approximate unemployment rate, at which
there are not upward or downward pressures on wages and price, as
full employment rate of unemployment. If unemployment falls to
level below the full employment rate, there will be upward pressure
on wages and prices. If unemployment rises to a very high rate,
there will downward pressure on wages and prices or wages and prices
will remain steady. In the middle is a level, or more likely a range,
where there is not pressure on wages and prices to rise or fall.
Economists do not know for certain what that unemployment rate
is, and even if they did, it does change over time. A current
consensus estimate is that the full employment rate of unemployment
is currently between 4.5 and 5.0 percent of the labor force being
unemployed. That is if unemployment were to fall to 4.0 percent of
the labor force, there will increased upward pressure on wages and
that may cause prices to begin to increase. If unemployment were 6
percent, workers competing for jobs may cause wages to fall. Costs
of producing fall and prices may fall. Or at least not increase as
rapidly.
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. 5 percent
b. 10 percent
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c. 10.5 percent
d. 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?
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.
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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.
Key Concepts
Inflation
Consumer price index (CPI)
Core consumer price index
Unemployment
Real income
Real GDP
Costs of inflation
Full employment
Relevant National Economic Standards
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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.
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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.
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Authors: Stephen Buckles
Vanderbilt University
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