Question

What is the Consumer Price Index (CPI), and how is it determined each month? How does the Bureau of Labor Statistics calculate the inflation rate from one year to the next? How does inflation affect the purchasing power of a dollar? How does it explain differences between nominal and real interest rates? How does deflation differ from inflation?

Short answer

CPI is an index to measure inflation in an economy.

$CPI=\frac{Priceofmostrecentmarketbasketinthespecificmonth}{Priceofmarketbasketinthebasemonth}\times 100$

An increase in the inflation rate decreases the purchasing power of a dollar.

Nominal interest is the real interest adjusted to the expected inflation rate.

Unlike inflation, the price level falls in deflation, and the currency's purchasing power strengthens.

The BLS calculates yearly inflation as follows:

$InflationRate=\frac{ChangeinCPIfrompreviousyeartonextyear}{CPIofpreviousyear}\times 100$

Step-by-step solution

Meaning of CPI and its calculation

Consumer Price Index is a tool to measure the rate of inflation in an economy. It takes the price of a market basket, including a certain number of consumer goods and services that an urban consumer generally consumes. It can be calculated yearly as well as monthly as per the following formula:

$CPI=\frac{Priceofmarketbasketinthespecificmonth}{Priceofmarketbasketinthebasemonth}\times 100$

Calculation of inflation rate

The Bureau of Labor Statistics calculates the inflation rate from one year to the next as per the following formula:

$InflationRate=\frac{ChangeinCPIfrompreviousyeartocurrentyear}{CPIofpreviousyear}\times 100$

The inflation rate is the percentage change in CPI from the previous year to the current year.

Effect of the inflation rate on the purchasing power of a dollar

As the inflation rate increases, the real income decreases; the dollar value reduces in real terms. More dollars are needed to purchase the same amount of goods, services or pay for loans. This is the loss in purchasing power of dollars occurring due to increased prices or inflation.

Inflation results in a difference in a nominal interest rate and real interest rate.

Inflation reduces the value of the nominal interest rate or interest payment by reducing the purchasing value of a dollar. Thus, the real income of the lenders falls. In order to maintain the real income (real interest rate), the nominal interest rate increases according to the inflation as shown below:

Nominal Interest Rate = Real Interest + Expected Inflation Rate

The nominal interest is the total effect of the real interest rate and expected inflation rate.

Difference between inflation and deflation

In inflation, the general price level goes up while the purchasing power of currency declines. Deflation causes an opposite effect by reducing the price level. The purchasing power of the currency appreciates. The disposable income and savings of people increase, and the creditors benefit as they receive the interest payment with higher real value.