This module begins by demonstrating how to combine prices of individual goods and services to create an index of prices, called the Consumer Price Index (CPI), which we then will use to calculate the rate of inflation. Inflation has costs and consequences for people and firms throughout the economy through their roles as lenders and borrowers, wage-earners, taxpayers, and consumers. The module discusses some imperfections and biases regarding CPI and inflation statistics, how to convert dollar values across time so as to make comparisons possible, and historical inflation around the world.
Next, we focus on money, its functions, the Banking System, the Federal Reserve System (Fed) and the Fed’s main policy tools. Last, we explain the relationship between money growth, inflation, and real GDP growth in the long-run via the Quantity Theory of Money. (1)
Inflation is a general and ongoing rise in the level of prices in an entire economy. Inflation does not refer to a change in relative prices. A relative price change occurs when you see that the price of tuition has risen, but the price of laptops has fallen. Inflation, on the other hand, means that there is pressure for prices to rise in most markets in the economy. In addition, price increases in the supply-and-demand model were one-time events, representing a shift from a previous equilibrium to a new one. Inflation implies an ongoing rise in prices.
A price index can be used to compare the real value of money between time periods. Have you heard the reminiscing of your elderly relatives about how things were so much better when they were kids? Maybe some of your elders brag about the $.05 Coca-Cola they enjoyed or the $.50 movies they went to when they were younger. When people often complain about the rising price of something, they are nearly always speaking of nominal prices, not real prices. So, in today’s dollars, how much was that famous $.05 Coca-Cola we’ve heard so much about?
If we use 1939 as the starting year, a $.05 Coca-Cola would be the equivalent of paying $.84 in 2013 — which for a 12oz can purchased from a grocery store, would be a bit on the high side (especially if considering the per unit price of purchasing in bulk). What about a $.50 movie? A $.50 movie in 1939 (the year Gone with the Wind was first released), would be $8.40 in 2013 — which is about the same as the 2013 average ticket price. Recall the concept of opportunity cost. If the price of a particular good is rising at a slower rate than other prices of other goods, then the opportunity cost of acquiring that item has actually fallen. (15)
Consumer Price Index
The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. CPI is the most commonly cited measure of inflation in the United States. The CPI is calculated by government statisticians at the U.S. Bureau of Labor Statistics based on the prices in a fixed basket of goods and services that represents the purchases of the average family of four. (16)
Reading the CPI Numbers from Newspaper Articles
- The CPI is defined to equal 100 for a period called the reference base period . The current reference base period is 1982-1984, so the average CPI during that period was 100.
- In July 2011, the CPI was 225.4. Thus, since 1982–84, prices have increased by 125.4 percent to July 2011.
- In May 2013, the CPI was 232.9. Thus, since 1982–84, prices have increased by 132.9 percent to May 2013.
- To find the increase/decrease in CPI as a percentage change we use this formula: (CPI 2 âˆ’ CPI 1 )÷CPI 1 ]x100. This is theinflation rate formula, to be formally introduced in the next few sections.
Constructing the CPI
The U.S. Bureau of Labor Statistics (BLS) conducts a survey of consumers (the Consumer Expenditure Survey) to determine the average market basket of goods and services purchased by an urban household. Then, each month the BLS records the prices of goods and services in the market basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices (which change) to determine the cost of the basket each month. (15)
The Eight Major Categories in the Consumer Price Index
- Food and beverages (breakfast cereal, milk, coffee, chicken, wine, full-service meals, and snacks)
- Housing (renter’s cost of housing, homeowner’s cost of housing, fuel oil, bedroom furniture)
- Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
- Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
- Medical care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
- Recreation (televisions, cable television, pets and pet products, sports equipment, admissions)
- Education and communication (college tuition, postage, telephone services, computer software and accessories)
- Other goods and services (tobacco and smoking products, haircuts and other personal services, funeral expenses) (15)
Student’s CPI Activity
Write down your own personal percentage expenditures for the list provided below. Try to make estimates of what percentage each item represents in terms of your annual income.
Fill in the blank lines with the average expenditures’ percentage spending for each category in the CPI Market Basket.
|Item||Percentage spending for each category in the CPI Market Basket (percent)|
|Food and Beverages||______________|
|Education and Communication||______________|
|Other goods and services||______________|
The purpose of this activity was to demonstrate that although the CPI is a statistically sound measure of the average change in the cost of a bundle of goods, it does not measure each and every individual person’s average change in cost. Indeed, there is at least one item on this list that has a markedly different weight of importance than the figure that you assigned to it. That item is education. Many students who are working their way through college are probably also paying their own tuition. Therefore, it is likely that the percentage in this category for you is much higher than the BLS reported figure.
However, the CPI is an “average” measure, thus if we were to find the averages of those percentages even in a small group of students, like our class size, chances are that the class average will be closer in value to the BLS percentages, than any individual percentage in itself.
CPI is not necessarily a reflection of how all consumers experience inflation. How does your personal market basket compare to that of the average American household? How does it compare to your basket of goods? How might the market basket of a group near the opposite end of the age scale – senior citizens – compare to the student market basket and the average market basket used by the CPI? Given that college students and seniors may rely on more fixed incomes than most groups (financial aid and Social Security, respectively), why do these price trends pose more of a problem for these groups? Why might using CPI measurements for different groups (a student CPI, a senior CPI, etc.) instead of just the general CPI be useful for targeted income assistance programs like financial aid and Social Security? How does the fact that the CPI tends to overstate the actual rate of inflation complicate this analysis? (1)