The Inflation Rate

A CASE STUDY THE INFLATION RATE September, 2005

Date of Announcement

October 14, 2005

Date of Next Announcement

November 16, 2005

Announcement

The consumer price index (CPI) during the month of September increased by 1.2 percent. The rate of increase in the consumer price index over the past twelve months has been 4.7 percent. In September, the core consumer price index, which excludes energy and food prices, increased by .1 percent (one-tenth of one percent). The core index has increased by 2.0 percent over the last twelve months.

Interactive question –

Given the difference in the changes in the consumer price index and the core index for the month of September, what must be happening to energy or food prices?

Energy or food Energy or food Energy or food prices must be prices could be prices must be increasing increasing or decreasing decreasing

Pop-up answer – Energy or food prices must be increasing

If one of the other answers is chosen, this should pop-up –

No, that is not correct. Think about the meaning of the indexes and try again. 1 Answer for teachers. The core index excludes changes in food and energy prices. Thus if the CPI and the core index increased, but the CPI increased by a significantly larger amount, it must be that food or energy prices increased at a much faster pace. (In fact, energy prices increased by an unusually rapid rate (12 percent) and food prices increased by 1.9 percent.)

A follow-up discussion question might be to ask what the relationship between the two measures has been over the last 12 months. Ask students to explain.

The answer is that the CPI has increased by 4.7 percent and the core by 2.0 percent over the last 12 months. Thus, food and energy prices together must have increased by more than the prices of all other goods. Energy prices have been the cause – a very large increase of 34.8 percent over the last 12 months.

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.

2 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 September, the consumer price index increased by 1.2 percent, after increasing .5 percent in each of the previous two months. In September, energy prices increased rapidly for the month in a row. Price indexes for transportation also rose. The annual rate of increase over the last three months was 9.4 percent and over the last 12 months, 4.7 percent. Annual inflation rates during all of 2002, 2003, and 2004 were 2.4, 1.9 and 3.3 percent. While a number of news stories will focus on the rather rapid increase in the consumer price index, we should be cautious about placing too much emphasis on any one month change. The core rate of inflation (increased by .1 percent in September) 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 September index compares to a .1 percent increase in the core rate of inflation in each of the previous five months. Core prices increased more slowly in the last three months than the overall index due to the rapid rises in prices of energy. The annual rate of increase in prices of energy over the last three months was 122 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 has not significantly influenced rates of increases in all other prices. Still the rapid rise in energy prices may eventually have a significant effect on all other prices in the economy. 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, prior to this month, 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 2 3 The Consumer Price Index

The seasonally adjusted consumer price index in September was 198.8. 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 the 1982-1984 period to September 2005 by 98.8 percent. A typical consumer good that cost one dollar in 1983 now costs almost $2.00. 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 September was 198.8, compared to 196.4 in August. The increase in prices from August to September was (198.8 – 196.4) / 196.4 = + 0.012. That means a monthly inflation rate of 1.2 percent. To convert this into an approximate annual rate, you can simply multiply by 12. This provides us an annual inflation rate of (1.2) (12) = 14.4 percent.

Table 1 Month Price Level Monthly Inflation Rate September 198.8 198.8 – 196.4 = .012 or 1.2 % August 196.4 196.4

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. 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.

4 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 42 % Recreation 6 % Transportation 17 % Education and communication 6 % Food and beverages 15 % Clothing 4 % Medical care 6 % Other goods and services 4 %

CPI Interactive Exercise

If a family’s annual income has increased from $20,000 to $45,000 over the last 22 years (from 1983 to 2005), what has happened to its real income? Its real income has:

Increased Decreased Not One cannot changed tell.

5 Pop-up - Increased

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 increased. There are two primary ways to make the calculation. Prices have almost doubled. Income has more than doubled. Thus, real income has increased as prices have increased by less than nominal (using current prices) income. A second method is that one could divide the current nominal income by 1.988 to get the current income in 1983 dollars. That is the real income. The result is that the current real income is $22,636. Thus real income has increased from $20,000 to $22,636.

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? The GDP price index was 200 in the first year and 210 in the second.

Increased Decreased Not changed

Pop-up - Yes, that is correct. Real GDP increased. 6 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.

Teachers - The correct answer is increased. Again there are two ways to arrive at the answer. Prices increased by 5 percent. GDP increased by 10 percent. Therefore, real GDP increased by 5 percent. 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 / 2.1 = $5.24 trillion.

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.

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. Decreased by 1 percent b. Decreased by 3 percent c. Increased by 1 percent d. Increased by 3 percent e. 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 c. 10.5 percent d. 105 percent

7 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. increased b. decreased c. stayed the same d. 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. increased b. decreased c. stayed the same d. 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.

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.

8 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) Unemployment Real income 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 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

9 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

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

10 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