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A CASE STUDY
THE INFLATION RATE
APRIL, 2005
Date of Announcement
May 18, 2005
Date of Next Announcement
June 15, 2005
Announcement
The consumer price index (CPI) during the month of April 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 3.7 percent.
In April, the core consumer price index, which excludes energy and food prices, did
not change from March. The core index has increased by 2.2 percent over the last
twelve months.
Interactive question –
Given the difference in the changes in the consumer price index and the core index,
what must be happening to energy or food prices?
Energy or food
prices must be
increasing
rapidly
Energy or food
prices must be
decreasing
rapidly
Energy or food
prices could be
increasing or
decreasing
Pop-up answer –
Energy or food
prices must be
increasing
rapidly
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Answer for teachers. The core index excludes changes in food and energy prices. Thus
if the CPI increased and the core index did not change, it must be that food or energy
prices rose rapidly. (In fact, both increased, with energy prices increasing at a very fast
rate.)
Figure 1
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.
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 set of
goods and services relative to the cost 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.
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Data Trends
In April, the consumer price index increased by .5 percent, after increasing .6 percent
in March and by .4 percent in February. In April, energy prices increased rapidly for the
third month in a row and food prices were up by 1.1 percent. Price indexes for apparel
fell.
The .5 percent increase continues a series of relatively large increases in the CPI.
The annual rate of increase over the last three months was 6.2 percent and over the last
12 months, 3.5 percent. Annual inflation rates during all of 2002, 2003, and 2004 were
1.6, 2.3 and 2.7 percent.
The core rate of inflation (unchanged 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 constant April index compares to a .4 percent
increase in the core rate of inflation in March and .3 percent in February. Core prices
increased more slowly in those months than the overall index due to the rapid rises in
prices of energy. Extra attention is given by forecasters to the core index as it tends to
show more lasting trends in prices.
In April, press coverage focused on the steady core index and emphasized that in
spite of the rise in the overall index, inflationary pressures, at least as measured by the
core index, are reduced.
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 trend over the last five months. It is however difficult to
tell what the trend over a longer period of time has been.
Figure 2 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 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.
Figure 2
The Consumer Price Index
The seasonally adjusted consumer price index in April was 194.2. The price index
was equal to 100 during the period from 1982 to 1984. The interpretation is that prices
in the market basket of goods and services purchased by the typical consumer increased
from the 1982-1984 period to April 2005 by 94.2 percent. A typical consumer good that
cost one dollar in 1983 now costs $1.94.
Can you calculate the monthly increase in prices given the CPI in April and in
March? In March, the CPI equaled 193.2.
It was
.5
percent.
It was
1.0
percent
It was
.94
percent.
It was
1.94
percent.
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The answer is “It was .5 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 194.2, compared to 193.2 in March. The increase in prices from
March to April was (194.2 – 193.2) / 193.2 = 0.0052 or a monthly inflation rate of .52
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 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. The result is an annual rate of inflation of 6.4
percent.
Table 1
Month
April
March
Price Level
194.2
193.2
Monthly Inflation Rate
194.2 – 193.2 = .0052 or .5 %
193.2
Annual Inflation Rate
1.005212 = 1.064 or 6.4 %
How the CPI is Calculated
Assume that there are only two goods included in the typical consumer’s purchases
and, in the base or the original year, each goods has a price of $10.00. Each consumer
purchases one of each good.
In the current year, the goods’ prices are $11 and $12. The index for the current year
would be the quantities purchased in the market basket in the base year (one each 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 ( 1 x $11 + 1 x $12 ) / ( 1 x $10 + 1 x $10 ) = $23 / $20 = 1.15. That is, prices
in the current year are 1.15 times the prices in the original year. Prices have increased
on average by 15 percent. That is true. The price of the first good increased by 10
percent. The price of the second good increased by 20 percent. By convention, the
indexes are multiplied by 100 and reported as 115 instead of 1.15.
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
index then is 1.00; 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 retail goods
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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.
Almost 100 urban areas are sampled by Bureau of Labor Statistics professionals
including visits and phone calls to 50,000 households and almost 25,000 retail stores and
offices.
For more information on the Bureau of Labor Statistics, visit www.bls.gov.
CPI interactive exercise.
Suppose a movie costs $8.00. If the price index in 194.2 now, approximately how
much did a soft drink cost in 1983 (the base year) if movie prices changed at the same
rate as all other prices?
$1.94
$4.12
$6.06
$15.53
Pop-up -
$4.12
Teachers - The correct answer is $ .52. To calculate, 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 .93 = $.52. A price increase of
93 percent would mean a rise from $.52 to $1.00. Prices have almost doubled.
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 and if we know that
overall output is rising? Choose as many as are relevant.
Increases
in supply
Increases
in demand
Decreases
in supply
Decreases
in demand
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Pop-up –
Increases
in demand
The correct answer - Increases in demand will cause prices to rise. 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.
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 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.
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.
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.
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CPI interactive exercise.
Calculate price indexes for the following a hypothetical secondary student’s budget.
a. What is the price index for April,
2005 (with a base period of April,
2004)?
b. What is the price index for April,
2004 (with a base period of April,
2004)?
c. What is the rate of inflation over the
year?
Item
DVDs
Hamburgers
Movies
Blouses
April, 2004
Quantity
2
5
3
1
Price
$ 17
$3
$7
$ 25
April, 2005
DVDs
Hamburgers
Movies
Blouses
3
6
2
1
$ 14
$4
$9
$ 30
a. The price index for April 2005 is equal to 105.
To calculate the April 2005 price index with a base period of April 2004, the
2004 quantities multiplied by the 2005 prices are divided by the 2004 quantities
multiplied by the 2004 prices and then the result is multiplied by 100.
b. The price index for April 2004 is equal to 100.
The quantities for 2004 are multiplied by the 2004 prices. Then the quantities for
2004 are multiplied by the 2005 prices. To calculate the April 2004 price index
with a base period of that month, the 2004 quantities multiplied by the 2004
prices are divided by the 2004 quantities multiplied by the 2004 prices and then
the result is multiplied by 100.
c. The annual rate of inflation over the period is 5 percent. (The index for April
2005 minus the index for April 2004, given that the first index is the base year.)
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
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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)
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
Food and beverages
Medical care
42 %
17 %
15 %
6%
Recreation
Education and communication
Clothing
Other goods and services
6%
6%
4%
4%
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Other questions
1. If inflation is 3 percent a year and average income increases by 5 percent, what has
happened to real average income?
a.
b.
c.
d.
e.
Decreased by 2 percent
Increased by 2 percent
Increased by 3 percent
Increased by 5 percent
Increased by 8 percent
2. If GDP increases by 3 percent over a year and the GDP price index increases by 4
percent, what has happened to real GDP?
a.
b.
c.
d.
e.
Decreased by 1 percent
Increased by 1 percent
Increased by 3 percent
Increased by 4 percent
Increased by 7 percent
3. Suppose the CPI was 150 for April of one year, and was 170 for April of the next
year. What is the approximate annual rate of inflation?
a.
b.
c.
d.
e.
70 percent
20 percent
17 percent
15 percent
13 percent
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?
a.
b.
c.
d.
Increased by 60 percent
Increased by 80 percent
Increased by 100 percent
Increased by 160 percent
5. The consumer price index has increased from 100 to 110 and average incomes have
gone from $30,000 to $33,000, what has happened to real income?
a.
b.
c.
d.
increased
decreased
not changed
One cannot tell.
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6. 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 average income?
a.
b.
c.
d.
increased
decreased
not changed
One cannot tell.
7. An Exercise for Understanding the Definition of Inflation
The following question and answer appeared in a recent publication of a major
financial firm.
“Have you experienced inflation recently? How was the inflation caused?
“Answer: Recent increases in gas prices; prices of fruits and vegetables
varying with seasons; bathing suits costing more in the spring and
summer, movie ticket prices being less or more depending on the area….”
Can you evaluate the question and answer?
Answers.
1. The correct answer is ‘b’. If income has increased by five percent and prices
have increased by three percent, the difference is the increase in real income.
Thus, real incomes have increased by two percent.
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 ‘e’. 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 (170 - 150) / 150 = .133 or 13.3 percent. Because this is over a twelvemonth period, it is an annual rate of inflation. Single month changes are slightly
more complicated to convert to annual results.
4. The correct answer is ‘c’. 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.
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5. The correct answer is ‘c’. Average income has increased by 10 percent. Prices
have increased by 10 percent [(110 – 100) / 100]. Thus real income must have
increased by approximately 10 percent.
6. The correct answer is ‘a’. Average income has increased by 20 percent. Prices
have increased by 10 percent [(275 – 250) / 250]. Thus real average income
must have increased by approximately 10 percent.
7. A better analysis focuses on the definition of inflation. Inflation is a
sustained increase in the overall level of prices. In a market economy,
prices vary in different seasons and in different areas. There are always
some prices increasing and others decreasing as demand and supply
conditions change in the markets. Inflation is an increase in average or
overall price levels. It is not increases in specific markets or differences
in prices in seasons or areas as described in the above question and
answer.
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
Vanderbilt University
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