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A CASE STUDY
THE INFLATION RATE
Date of Announcement
January 15, 2004
Date of Next Announcement
February 20, 2004
Announcement
The consumer price index (CPI) during the month of December 2003 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 1.9 percent.
In December, the core consumer price index, which excludes energy and food prices,
increased by .1 percent. The core index has increased by 1.0 percent over the last twelve
months.
Interactive question –
Is the most recent month rate of inflation and the rate of inflation over the last 12
months relatively high, low, or about the same as the rates over the last decade?
Current
inflation is
higher
Current
inflation is
about the
same
Current
inflation is
lower
Answer for teachers. Current inflation is lower than it has been over the last decade.
See 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.
Goals of Case Study
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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 sustained increase in the overall level of prices. The most widely
reported measurement of inflation is the consumer price index (CPI). The CPI measures
the cost of a fixed basket of goods relative to the cost of that same basket of goods in a
base (or previous) year. Changes in the price of this basket of goods approximate
changes in the overall level of prices paid by consumers.
Data Trends
In December, the Consumer Price Index increased by .2 percent, after decreasing .2
percent in November, and not changing in October. For the last quarter of the year, the
rate of change was equal to zero. In December, increases in food and medical care
prices contributed to the increase.
Table 1.
The core rate of inflation (+ .1 percent in December) 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 December increase compares to a 0.2
percent increase in the core rate of inflation in October and a 0.1 percent decrease in
November. Core prices actually increased more slowly this month than the overall
index because food price increases were such a large part of the overall increase.
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Figure 1 below shows recent inflation data reported for each month. Inflation
increased in 1999 and 2000 when compared to1998, slowed throughout much of 2001,
then increased slightly in 2002, and slowed slightly in 2003. What is really quite
obvious from Figure 1 is that the changes in inflation from month to month are much
more dramatic from 1999 on, when compared to 1998. 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 longer-term trends and that is
why it is often featured in news reports. See figure 2.
Figure 1
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 below. The very high rates of inflation in the
early and late 1970s were accompanied by very rapid rises in prices of oil. 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 3
The Consumer Price Index
The seasonally adjusted consumer price index in December was 185.0. 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 December 2003 by 85 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 December was 185.0,
compared to 184.6 in November. The increase in prices from November to December
was (185 -184.6) / 184.6 = 0.0022 or a monthly inflation rate of 0.22 percent. It is
reported to the nearest one-tenth of a percent, in this case, 0.2 percent. To convert this
into an annual rate, you could simply multiply by 12. This approximates an annual
inflation rate of (0.2) (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.
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Month
December
November
Price Level
185
184.6
Monthly Inflation Rate
185 – 184.6 = .0022 or .2 %
184.6
Annual Inflation Rate
1.002212 = 1.0267 or a
2.7 % increase in prices
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).
CPI interactive exercise.
Suppose a typical lunch sandwich currently costs $4.00. If the consumer price index in
185 now, approximately how much did a sandwich cost in 1983 if its price changed at
the same rate as all other prices?
$2.15
$3.40
$4.00
$7.40
Teachers - The correct answer is $2.15. 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, $4.00 / 1.85 = $2.16. A
price increase of almost 85 percent would mean a rise from $2.16 to $4.00.
Prices have almost doubled since 1983.
Costs of Inflation
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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.
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.
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Using the CPI –
1. Given the following data, calculate the total inflation between 2000 and 2003.
CPI
2000
2001
2002
2003
174.6
177.3
181.6
185.0
Average income in your
community
2000
2001
2002
2003
$40,000
$41,000
$42,000
$43,000
2. Given the above data, what has happened to real income in your community
from 2000 to 2003?
3. Are people better off or worse off? Why?
Answers.
1. 6.0 percent. 185 / 174.6 = 1.0596 or an increase of 6 percent.
2. Average income has gone up 7.5 percent. $43,000 / $40,000 = 1.075 or an
increase of 7.7 percent. Because average income has increased by a larger
percentage than the price level, the average “real” income has increased by
approximately 1.5 percent.
3. If these figures are accurate, people in this community are slightly better off.
That is, their incomes will buy 1.5 percent more than they would in 2000.
Other questions for students
1. What is inflation?
2. Calculate price indexes for the following a hypothetical secondary student’s budget.
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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. If prices increase by five percent in a year, what effect does this have on the
purchasing power of individuals in the economy?
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
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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.
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. Students may answer that purchasing power goes down since their money is
worth less, and consequently they cannot buy as many goods and services. The
value of money does fall. However, they are ignoring that inflation affects wages
as well. If average incomes and prices of goods and services have increased by
five percent, the purchasing power of average income remains unchanged.
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.
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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
Erin Kiehna
Vanderbilt University
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