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A CASE STUDY THE INFLATION RATE Date of Announcement May 14, 2004 Date of Next Announcement June 15, 2004 Announcement The consumer price index (CPI) during the month of April 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 2.3 percent. In April, the core consumer price index, which excludes changes in energy and food prices, increased by 0.3 percent. The core index has increased by 1.8 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 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. Recent news articles have discussed slight recent increases in inflation. In fact, students, who have been reading recent economic news, may say that inflation has increased when compared to last fall. Table 1 Information for Teachers 1 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 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 month or year. Changes in the prices of those goods approximate changes in the overall level of prices paid by consumers. Data Trends In April, the Consumer Price Index increased by .2 percent, after increasing .3 and .5 during February and March. In April, increases in housing and medical care prices were largely responsible for the overall increase. The prices of education and communication also increased during the month. The core rate of inflation (.3 percent in April) 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 April increase compares to 0.2 and 0.4 percent increases in the core rate of inflation in the previous two months. Core prices increased slightly faster than the overall index as energy prices did not increase as rapidly as other prices. Seventy-nine percent of the goods and services included in the overall index are Figure 1 2 included in the core index. 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. Inflation rates in 2004 are slightly higher than they have been over the last two years and that is causing concern among many observers. They are still low, but economic news is beginning to focus on the possibility of future Federal Reserve tighter monetary policy designed to reduce inflationary pressures as they occur. (Since this announcement, energy prices have increased significantly.) 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 increased Figure 2 in 1999 and 2000 when compared to1998, fell throughout much of 2001, and then 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 longer-term 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 experience of 2001, 2002, and 2003 as no or zero inflation. Figure 4 The Consumer Price Index The seasonally adjusted consumer price index in April was 187.6. 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 19821984 period to April 2004 by 87.6 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 April was 187.6, compared to 187.2 in March. The increase in prices from March to April was (187.6187.2) / 187.2 = 0.0021 or a monthly inflation rate of .21 percent. It is reported to the 3 nearest one-tenth of a percent, in this case, .2 percent. To convert this into an annual rate, you could simply multiply by 12. This approximates an annual inflation rate of (.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, which in this case will give a slightly larger result. Month April March Price Level 187.6 187.2 Monthly Inflation Rate 187.6 – 187.2 = .0021 or .2 % 187.2 Annual Inflation Rate 1.002112 = 1.026 or 2.6 % Deflation Deflation is a fall in prices. Most observers would describe the rates of change in prices we experienced in much of 2001, 2002, and 2003 as practically no inflation or, at least, such low rats of inflation that inflation was not a serious problem. With inflation so low, it is not surprising to experience a negative rate of inflation (or deflation) in some months. April, May, 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 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 and the Consumer Price Index, 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 percent of the market basket is made up of goods that consumers purchase. Thirty-two percent is housing. The other twenty-eight percent includes other services. 4 CPI interactive exercise. Suppose a ticket to a movie costs $8.00. If the price index in 187.6 now, approximately how much did a movie ticket cost in 1982-84 if its price changed at the same rate as all other prices? $1.00 $4.00 $7.00 $15.00 Teachers - The correct answer is $4.00. ($4.26 to be exact.) 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, $8.00 / 1.876 = $4.26. A price increase of more than 87 percent would mean a rise from $4.26 to $8.00. 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. 5 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. 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? (More than one may be correct.) Increase in supply Increase in demand Decrease in supply Decrease in demand The correct answers – Increase in demand and decrease in supply. 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 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 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. 6 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. 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 prices increase by 2 percent over a year and average income increases by 5 percent, what has happened to real income? a. b. c. d. 2 percent 3 percent 5 percent 7 percent 2. If GDP increases by 6 percent over a year and the GDP price index increases by 2.5 percent, what has happened to real GDP? a. b. c. d. 2.5 percent 3.5 percent 6.0 percent 8.5 percent 3. If over a several year period, the consumer price index has increased from 180 to 198 and average incomes have gone from $40,000 to $42,000, 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 200 to 240 and average income has gone from $30,000 to $36,000, what has happened to real income? a. increased 7 b. decreased c. not changed d. cannot tell Answers. 1. The correct answer is ‘b’. If income has increased by 5 percent and prices have increased by 2 percent, the difference is the increase in real income. Thus, real incomes have increased by 3 percent. 2. The correct answer is ‘b’. GDP in current prices has increased by 3.5 percent more than the change in the price level. Thus real GDP must have increased by 3.5 percent. 3. The correct answer is ‘b’. Prices have increased by 10 percent [(198 – 180) / 180]. Average income has increased by 5 percent. Thus real income must have decreased by approximately 5 percent. 4. The correct answer is ‘c’. Prices have increased by 20 percent [(240 – 200) / 200]. Average income has increased by 20 percent. Thus real income must have remained the same. Other questions for students 1. If gasoline prices increase, are we experiencing inflation? 2. Calculate price indexes for the following hypothetical secondary student’s budget. a. What is the price index for May, 2003 (with a base period of May, 2003)? b. What is the price index for May, 2004 (with a base period of May, 2003)? c. What is the rate of inflation over the year? Item DVDs Hamburgers Shoes Pants May, 2003 Quantity 2 5 1 1 Price $ 17 $3 $ 40 $ 50 May, 2004 DVDs Hamburgers Shoes Pants 3 6 1 1 $ 14 $4 $ 40 $ 60 8 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 200? 5. Given the following data, calculate the rate of inflation between 2001 and 2002. 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 annual 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 for students”. 1. Not necessarily. Inflation is 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 May, 2003 is equal to 100. The quantities for 2003 are multiplied by the 2003 prices and the results are added together. To calculate the May, 2003 price index with a base period of that month, the sum of the 2003 quantities multiplied by the 2003 prices is divided by the sum of the 2003 quantities multiplied by the 2003 prices and then the result is multiplied by 100. The quantities and prices are all the same and the result says that there is no change. b. The price index for May, 2003 is equal to 106.5. To calculate the May, 2004 price index with a base period of May, 2003, the sum of the 2003 quantities multiplied by the 2004 prices is divided by the sum of the 2003 quantities multiplied by the 2003 prices (148/139) and then the result is multiplied by 100. 9 c. The annual rate of inflation over the period is 6.5 percent. (The index for May, 2004 minus the index for May, 2003, divided by the May, 2003 index.) 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 recent rates in the U.S.) 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 200 would mean that consumer prices on average are 2.5 times higher than their 1970 levels. The percentage increase is (200 - 80) / 80 = 120/80 or 150 percent. One does not need to calculate the base year period. 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 10 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 11 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 12