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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
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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
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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
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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.
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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.
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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.
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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. 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
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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
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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.
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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
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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.
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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