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A CASE STUDY
THE MAY INFLATION RATE
June 14, 2006
Date of Announcement
June 14, 2006
Date of Next Announcement
July 19, 2006
Announcement
The consumer price index (CPI) during the month of May increased by .4
percent (four-tenths of one percent). The rate of increase in the
consumer price index over the past twelve months has been 4.2 percent.
In May, the core consumer price index, which excludes energy and food
prices, increased by .3 percent (three-tenths of one percent). The core
index has increased by 2.4 percent over the last twelve months.
Interactive question –
Is the rate of inflation, as measured by changes in the overall CPI,
during May particularly high, low, or just about equal to recent monthly
levels?
Current
inflation is
higher than it
has been.
Current
inflation is
about the
same as it has
been.
Current
inflation is
lower than it
has been.
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Pop-up answer –
Current
inflation is
about the
same as it has
been.
If one of the other answers is chosen, this should pop-up –
No, that is not
correct. Inflation in
May was about the
same as it has been.
Is the rate of inflation, as measured by the core CPI, over the last 12
months particularly high, low, or just about the same when compared to
changes over the previous year or two?
Current
inflation is
higher than in
recent years.
Pop-up correct answer –
Current
inflation is
about the same
as recent years.
Current
inflation is
lower than in
recent years.
Current inflation is
higher than in recent
years.
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If one of the other answers is chosen, this should pop-up –
No, that is not correct.
Inflation over the last 12
months is higher than it has
been in the last several years.
For teachers – Inflation during May and the last several months appears to
be increasing. Inflation, while still relatively low compared to the highest
rates the U.S. has experienced, does appear to be increasing.
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.
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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 May, the consumer price index increased by .4 percent, after
increasing .6 percent in April and .4 percent in March. In May, energy
prices increased once again. The price index for transportation also rose
relatively rapidly.
The annual rate of change over the last three months was an increase of
5.7 percent and over the last 12 months, an increase of 4.2 percent. Annual
inflation rates from 2002 through 2005 were 2.4, 1.9, 3.3 and 3.4 percent.
The core rate of inflation (increased by .3 percent in May) 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 May index compares to .3 percent increases in the
core rate of inflation in each of the previous two months. Core prices
increased more slowly in the last two months than the overall index due to
rises in prices of energy. The annual rate of increase in prices of energy
over the last three months was 35 percent. Energy prices have increased
at a 23.6 percent rate over that last 12 months.
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 over the last several years has
not significantly influenced rates of increases in all other prices, but may
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be beginning to have an upward pressure on other prices. The rapid rise in
energy prices may eventually have a significant effect on all other prices in
the economy.
Figure 1
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 one over the
last several months. It is however difficult to tell what the trend over a
longer period of time has been.
Figure 2 shows the changes in the core index compared to the changes in
the overall CPI. Obviously the changes in prices other than energy and food
have been significantly smaller than the changes in the overall index.
Figure 2
Figure 3 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 the last few months, as high and they are not, when
compared to those of the past thirty years. However, the recent rates of
inflation 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 3
Current concerns
The rate of inflation appears to be increasing. The causes are likely to
be the effects of relatively low interest rates causing a healthy growth in
spending. The second is the rapid rise in petroleum and gasoline prices
raising the prices of energy and raising costs of producing a wide variety of
goods.
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The chairman of the Federal Reserve and others have stated that the
present trend in increasing rates of inflation should be met with an
increasingly restrictive monetary policy. The current inflation
announcement is being discussed as evidence that the Federal Reserve will
very likely continue its string of increases in the federal funds interest
rate. (See the discussion of monetary policy below and the most recent
Federal Reserve case study.)
The Consumer Price Index
The seasonally adjusted consumer price index in May was 201.9. 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 May, 2006 by 101.9 percent. A typical consumer
good that cost one dollar in 1983 now costs $2.02.
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
May was 201.9, compared to 201.0 in April. The increase in prices from May
to April was (201.9 – 201) / 201 = .004. That means a monthly inflation
rate of .4 percent or four-tenths of one percent.
To convert this into an approximate annual rate, you can simply multiply
by 12. This provides us an annual inflation rate of (.4) (12) = 4.8 percent.
Table 1
Month
May
April
Price Level
201.9
201
Monthly Inflation Rate
201.9 – 201 = .004 or .4 %
201
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
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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.
CPI Interactive Exercise
If a family’s annual income has increased from $40,000 to $50,000 over
the last 23 years (from 1983 to 2006), what has happened to its real
income? Its real income has:
Increased
Pop-up
correct
answer -
Decreased
Not
changed
One cannot
tell.
Decreased
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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 decreased. There are two primary ways
to make the calculation. Prices have doubled over that time period. Income
in this case has increased by 25 percent. Thus, real income has decreased
as prices have increased by more than nominal (using current prices) income.
A second method is that one could divide the current nominal income by
2.019 to get the current income in 1983 dollars. That is the real income.
The result is that the current real income is $24,765. Thus real income has
decreased from $40,000 to $24,765.
CPI Interactive Exercise
If GDP in a country increases from $12 trillion to $13 trillion from one
year to the next, what has happened to real GDP? Assume that the GDP
price index was 150 in the first year and 160 in the second.
Increased
Decreased
Not
changed
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Pop-up – If the first answer is chosen.
Yes, that is correct.
Real GDP has increased.
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 6.7 percent. GDP increased by
8.3 percent. Therefore, real GDP did increase.
A more exact calculation is to calculate real GDP in both cases. In the
first year, real GDP equals $11 trillion / 1.50 = $7.33 trillion in the base
year’s dollars. In the second year, real GDP equals $12 trillion / 1.60 = $7.5
trillion. Another measure, the GDP price index, is discussed below and it is
the one that is actually used in relationship to GDP.
Causes of Inflation
To understand causes of inflation, think of markets for individual products.
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
Teachers - The correct answer - Increases in demand will cause
prices to rise at the same time quantity is increasing. 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.
What might cause prices to increase if we observe that prices are rising in
most markets and if we know that overall output is falling? Choose as many
as are relevant.
Increases
in supply
Pop-up –
Increases
in demand
Decreases
in supply
Decreases
in demand
Decreases in
supply
Teachers - The correct answer - Decreases in supply will cause prices
to rise while at the same time output is falling. If the cause of inflation
is an increase in demand, then output should be increasing.
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 fullemployment level of real GDP, pull up prices. It is not just rising spending.
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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 costpush 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.
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.
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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 longterm 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.
Discussion questions
Teachers – This is a good opportunity to ask students to discuss each
possible cost of inflation. You might divide the class into five small groups
and ask each to select one of the above costs, prepare an example that will
illustrate the cost, and then present the examples to the rest of the class.
Full employment
Economists define the approximate unemployment rate, at which there
are not upward or downward pressures on wages and price, as full
employment rate of unemployment. If unemployment falls to level below the
full employment rate, there will be upward pressure on wages and prices. If
unemployment rises to a very high rate, there will downward pressure on
wages and prices or wages and prices will remain steady. In the middle is a
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level, or more likely a range, where there is not pressure on wages and
prices to rise or fall.
Economists do not know for certain what that unemployment rate is, and
even if they did, it does change over time. A current consensus estimate is
that the full employment rate of unemployment is currently between 4.5
and 5.0 percent of the labor force being unemployed. That is if
unemployment were to fall to 4.0 percent of the labor force, there will
increased upward pressure on wages and that may cause prices to begin to
increase. If unemployment were 6 percent, workers competing for jobs may
cause wages to fall. Costs of producing fall and prices may fall. Or at least
not increase as rapidly.
Policy discussion question
What should the Federal Reserve do with its monetary policy given this
month’s consumer price index announcement? Explain why.
Policy question answer.
There are a number of possible issues to discuss with this question. The
trend has been one of increasing inflation. That may indicate that the
Federal Reserve should slow the growth of the money supply by raising the
target federal funds rate (by selling bonds), the discount rate, or the
required reserve ratio.
A more advanced approach to the question is that monetary policy has a
significant lag. Perhaps the recent more restrictive policy changes are
beginning to work and that nothing should be changed with current policy.
In any case, one should caution students to not place too much emphasis
on one month change. The trend and what that trend indicates about the
future are what are important in deciding policy.
Your class might be divided into three groups with each taking a possible
position – a restrictive policy, no change in policy, and a stimulative policy.
The latest Federal Reserve, GDP, and unemployment cases might be
considered as part of the evidence to be used.
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Questions
1. If the annual rate of inflation is 2 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
Decreased by 3 percent
Increased by 3 percent
Increased by 5 percent
Increased by 7 percent
2. Suppose the CPI was 150.0 in one year and 157.5 in the next year. What
was the annual rate of inflation for those 12 months?
a.
b.
c.
d.
e.
5 percent
7.5 percent
10 percent
150 percent
157.6 percent
3. Suppose the CPI increased by 1.0 percent in one year and by 1.5 percent
the next year. Which of the following best describes the situation?
a.
b.
c.
d.
Inflation is
Inflation is
Inflation is
Inflation is
decreasing
increasing
decreasing, but is not a serious problem.
increasing, but is not a serious problem.
4. Suppose the CPI increased by 3.0 percent in one year and by 3.5 percent
the next year. Which of the following best describes an appropriate
monetary policy?
a.
b.
c.
d.
e.
Nothing should be done as this is not a serious problem.
The Federal Reserve should purchase bonds in the open market.
The Federal Reserve should sell bonds in the open market.
The federal government should increase spending.
The federal government should decrease spending.
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Answers to questions.
1. The correct answer is ‘c’. If income has increased by 5 percent and
prices have increased by 2 percent, real incomes have had to
increase. An approximation is that real incomes have increased by 3
percent. That is, the increase in income (5 percent) minus the
increase in the price level (2 percent).
2. The correct answer is ‘b’. Prices have increased 5 percent. The
change in the index is 7.5. The first year is 150. Thus the annual
inflation is 7.5 / 150 or 5 percent.
3. . The correct answer is ‘d’. Prices have increased in both years and
slightly faster in the second year. However, few would claim that
either year is a serious rate of inflation. Zero inflation, or inflation
rates that are of no concern are between 1 and 2 percent.
4. The correct answer is ‘c’. These inflation rates are somewhat more
serious and may signal the need for a more aggressive monetary
policy. The last two answers are fiscal policy and are thus incorrect.
The appropriate monetary policy is to slow down the growth in
spending and the Federal Reserve would do that by selling bonds and
causing interest rates to increase.
Key Concepts
Inflation
Consumer price index (CPI)
Core consumer price index
Unemployment
Real income
Real GDP
Costs of inflation
Full employment
Monetary policy
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Fiscal policy
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 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
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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
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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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