A CASE STUDY
THE INFLATION RATE
Date of Announcement
October 18, 2002
Dates of Future Announcements
November 19, 2002
Announcement
The seasonally adjusted rate of change in the consumer price index during the month
of September 2002 was 0.2 percent (an increase of two-tenths of one percent). The rate
of increase in the consumer price index over the past twelve months was 1.5 percent.
In September, the core consumer price index, which excludes energy and food
prices, increased by 0.1 percent.
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.blsgov/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.
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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 September, the Consumer Price Index rose by 0.2 percent, slightly lower than the
0.3percent increase in August. In September, large increases in the price indices for
energy (.7%) caused the inflation rate to increase, while a downturn in the costs of
education and communication (-.2%) helped moderate the rate... The large increase in
the energy index was due to rising gasoline prices in September, advancing for the third
consecutive month.
The core rate of inflation (0.1 percent in September) 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 September increase compares to a 0.3
percent increase in the core rate of inflation for August.
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,
and then has increased slightly in 2002. 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. 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
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The Consumer Price Index
The seasonally adjusted consumer price index in September was 180.8. 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 September 2002 by 80.8 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 September was 180.8,
compared to 180.5 in August. The increase in prices from August to September was
(180.8-180.5) / 180.5 = 0.0017 or a monthly inflation rate of .17 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.
Month
September
August
Price Level
180.8
180.5
Monthly Inflation Rate
180.8-180.5 = 0.0017 or 0.17 %
180.5
Annual Inflation Rate
1.001712 = 1.0206 or 2.1%
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?
“Suggested 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?
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.
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.
Causes Of Inflation
Over short periods of time, inflation can be caused by increases in costs or an
increase 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.
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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.
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.
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 percentages that are currently used to describe the categories of goods
and services that market basket are as follows.
Food and beverages
Housing
Clothing
Transportation
Medical care
16 %
41 %
4%
17 %
6%
Recreation
Education
Communication
Other goods and services
6%
3%
3%
4%
Using the CPI as an Inflation Index
The Social Security Administration announced on October 18 that Social Security
payments, beginning in January 2003, will increase by 1.4 percent. Annual changes in
Social Security payments are based on changes in the consumer price index. The rate of
change in consumer prices from October of one year through September of the next is
used to calculate the appropriate change in the Social Security payments for the
following year. The purpose of the adjustment is to maintain the real purchasing power
of the Social Security payments, that is, to reduce the cost of inflation for those who
might otherwise be living on fixed incomes.
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Income tax brackets and deductions also change according to changes in the
consumer price index. Private contracts often also reference changes in inflation as
measured by the consumer price index.
An Exercise
There have been many news reports lately about the rising costs of college tuition.
In 2000, the average cost of tuition at four-year private colleges was $16,233 compared
to $17,123 in 2001. At four-year public institutions, the average tuition increased from
$3,487 to $3,754. What was the rate of increase in tuition for public and private
colleges? Did the real cost of tuition increase?
One way to approach the exercise is to compare rates of increase in tuition with the
rate of inflation. In essence, is tuition increasing at the same rate as inflation, at a
faster rate, or at a slower rate?
The consumer price indexes for 2000 and 2001 were 172.2 and 177.1. To calculate
the rate of inflation, find the increase and divide it by the 2000 index. (177.1172.2)/172.2 = 2.8 percent. The increase in private college tuition was $890, or an
increase of 5.5% ($890/$16,233). This exceeds the rate of inflation. The increase in
public college tuition was $267, or an increase of 7.7% ($267/$3,487). This also
exceeds the rate of inflation.
An alternative method that is often used to compare incomes, levels of output, and
prices is to change the 2001 figure into terms of 2000 dollars. Thus we would create a
new index showing the increase in prices. (177.1/172.2 = 1.028) To report the new
number as an index, we normally multiply it by 100. However to express the 2001 figure
in 2000 dollars, we divide the 2001data by the new index. (Thus for the public tuition,
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$3,754/1.028 = $3,652. Given that the 2001 tuition (in terms of 2000 dollars) is larger
than the 2000 tuition (in terms of 2000 dollars), we would describe the change as an
increase in the real cost of going to college.
Interactive questions for students
1. What is inflation?
2. Calculate a consumer price index in 2001 for the following market basket of goods
(using 2001 as a base year).
2001
3 boxes of cheerios $4.00 each
2 pounds of bananas $1.00 per pound
2 gallons of milk
$3.00 per gallon
2002
4 boxes of cheerios $5.00 each
1 pounds of bananas $2.00 per pound
2 gallons of milk
$3.00 per gallon
3. Calculate a consumer price index in 2002 (using 2001 as a base year).
4. Given this market basket, what is the annual rate of inflation from 2001 to 2002?
Answers to go with interactive questions.
1.
2.
3.
4.
A continual increase in the average price level.
100.
125.
25 percent.
Notes to teacher.
1. 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. For the base year, the price index is calculated by first taking the 2001 quantities
times the 2001 prices. As it is the base year, that number is divided by itself and
multiplied by 100.
3. The price index is calculated by first taking the 2001 quantities times the 2001
prices. The 2002 prices are then multiplied by the 2001 quantities. Then the latter
(the amount spent if only the prices change) is divided by the 2001 prices times 2001
quantities and multiplied by 100. ($25/$20) x 100 = 125. The most common mistake
will be to calculate the second year with the 2002 prices and 2002 quantities.
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4. The 2001 index is subtracted from the 2002 index and the difference is divided by the
2001 index. (125-100)/100 = .25 or 25 percent. An easier way, given that the first
year is the base year of 100 is simply to compare the two directly. An index of 125
means that prices have gone up by 25 percent since the base year.
Other Questions For Students
1. 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?
2. 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?
3. If prices increase by five percent in a year, what effect does this have on the
purchasing power of individuals in the economy?
4. What are the costs of increased rates of inflation?
Sample Answers For Additional Questions
1. 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.
2. 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.
3. 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.
4. Large increases in the price level make it difficult for businesses to estimate future
levels of revenues and costs of products. This may discourage some businesses from
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expanding and making investment decisions. In addition, real income may be
redistributed as some incomes rise parallel to or faster than rates of inflation and
others are slower to rise. Higher inflation rates lead to higher interest rates. As a
result, more resources will be devoted to managing financial assets. Those
resources could be used in times of lower inflation to produce other goods and
services.
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
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
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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
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
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Bharath Subramanian
Vanderbilt University
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