What students should know:

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1 Inflation and Changes over Time Terms and Concepts to Cover: Inflation Rate Inflation Percentage Calculating Inflation (Year Later minus Year Earlier Year Earlier = Rate x 100) Index Year = 100 CPI CPI Changes (Index Year 2 minus Index Year 1 Index Year 1 = Rate x 100) GDP Deflator Nominal Interest Real Interest (Nominal Interest Rate minus Inflation = Real Interest) Stagflation Rule of 70 Anticipated Inflation Demand Pull Inflation Cost Push Inflation Deflation Disinflation Economic Norms Methods: Notes and Discussion of Inflation and Rates Notes on Consumer Price Index Definition of GDP Deflator Practice Problems (CEE: Lesson 2-3, 2-4, 2-5) What students should know: How to adjust for inflation over time Index years must always be 100. Nominal versus Real How to apply the Rule of 70 Why the CPI measures a smaller part of the economy than the GDP deflator

2 Creating the CPI First, create a base year. This base year will be an index number of. This index system will be used for any year to year comparisons involving inflation. Assume that the total CPI expenses for a selected year are established as a base year. In 2006, in the US, the expenses happened to be $48,398 for an urban family of four. 48,398 48,398 = 1 as a rate of change for the year. To index multiply the rate by x100 = CPI of 100 which is the Base Year. Then, in 2007, the total expenditures for the family of four were $48,898 Instead of calculating the difference the $500 of expenses made, index it. 48,898 48,398 = 1.01 as a rate of change 1.01x100 = CPI of 101 The inflation rate formula is now applied: Year later minus Year earlier Year earlier = rate of change. The rate of change x 100 = inflation %. Now, the 2006 to 2007 change is much easier with the index than using the raw numbers: = 1/100 =.01 (rate of change) x 100 = 1% inflation for the year

3 What is the Consumer Price Index? The CPI is data collected by the and is used to measure the general cost of living for urban consumers. This tracks the changes in costs of living over time. It gives a measure of the effect of. CPI data has been collected since, published by the BLS since, and calculated by the Fed Reserve Banks back to for their regions. There are several variations and sets of data being collected. Examples are a CPI for Elderly Consumers and a CPI for Wage Earners. However, the main CPI that is published widely is the CPI for. This is due to the fact that the vast majority of US residents live in urban and sub-urban areas. What Kind of Data is Collected? The BLS collects data from thousands of families covering consumption categories of across 38 geographic regions of the nation. Here are the top consumption items that make up most of urban expenditures:

4 Issues Concerning the CPI The BLS is criticized for being too slow to add items to the list. The BLS does not adequately adjust for quality improvements. The basic, urban CPI does not adequately account for the ways that consumers change purchasing habits of substituting cheaper goods for those rising more quickly in prices In 1995, Congress sponsored a study that concluded that the CPI overstates inflation by 0.8 to 1.5% per year. This would cause significant issues over longer periods of time, especially in the development of stabilization policies. The Fed does use multiple variations of CPI data to moderate such issues. One is the rate which does not include food price changes or energy price changes as part of the determination of Monetary Policies. The data is being used and published more and will be shown to have significant relevance to government policies. The CPI and Inflation Why So Much Concern About Inflation? First, there are three types of Inflation: 1. Demand-Pull Inflation 2. Cost-Push Inflation 3. Political Inflation

5 The Chained CPI The basis for this measure is that as prices rise for certain products consumers will turn to lower cost alternatives. The usual example is that beef prices rise, consumers switch to cheaper chicken. Therefore, the amount of inflation stated in the CPI is an overstatement of the effect on consumers. The Chained CPI takes these adjustments into account and therefore reports a lower inflation rate for most years. Why is this important? The government uses the CPI measure for many budget changes: annual increases in Social Security payments (COLAs) annual government pensions annual veteran s benefits tax bracket changes that determine how quickly workers might move into higher tax ranges the establishment of the poverty level for assistance programs A Chained CPI system would: cause in Social Security, pension, and benefit program adjustments cause workers to move into higher tax brackets more quickly cause some to be moved out of poverty ranges more quickly reduce government spending targets For 2013, estimates have been made that the CPI would increase COLA payments by 1.7%. The Chained CPI would increase COLA payments by only 1.4%. For items like Social Security, the reduction of payments would be about $102 billion in the next 10 years. (source: Associated Press article, published in the Houston Chronicle, 12/7/2012)

6 CPI and Inflation Sample Problems (Some will require calculators since they are slightly more complex than numbers that will be found on the AP) The BLS uses 1984 as the Index Year. Prices are national averages /16 Rate of Change CPI Min. Wage $ 3.35 $ 7.25 Min. Wage (If ) $ 3.35 $ Gasoline per gallon $ 1.20 $ 2.60 Gasoline (If ) $ 1.20 $ 4.00 Movie Ticket $ 2.50 $ New Car $ 6,000 $ 30,000 New Home $90,000 $250,000 Yr. of Public College $ 5,800 $ 24,000 Yr. of Private College $13,000 $ 60,000 Median Family Income $22,500 $ 53,000 Inflation % 2043/44 The formula is consistent for each problem. With either the CPI number or the actual costs, Year later minus Year earlier Year earlier = rate of change. Rate of change x 100 = inflation % The same system can be applied to predicting future costs. If one assumes that inflation into the future will remain at the same rate as in the past, then the same formula applies, only the unknown is now the Year later and the known is the rate of change. The difference will be a little algebra. x minus Earlier year Earlier year = rate of change (as given above), x minus Earlier year = rate x Earlier year, x = (rate x Earlier year) plus Earlier year.

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