3.2 Macroeconomics

How Is Inflation Measured

Each month, the US Bureau of Labor Statistics (BLS) collects price data and publishes measures of inflation. The measure most commonly cited is the consumer price index (CPI). The CPI is based on the cost of buying a fixed basket of goods and services comprising items a typical urban family of four might purchase. The BLS divides these purchases into eight major categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services.

Sometimes you will hear a core inflation index being quoted. This index is calculated by excluding volatile economic variables, such as energy and food prices, from the CPI measure. Energy and food prices can jump around from month to month because of weather or other short-lived events. A drought can cause food prices to spike; a temporary rise in gasoline prices can occur as a hurricane approaches the coastline. These types of shocks are transitory in nature and do not represent underlying economic conditions.

While the CPI and the core inflation index are based on the prices that households pay, the producer price index (PPI) is based on prices that producers of goods and services pay for their supplies and raw materials. The PPI captures price changes that occur prior to the retail level. Because it indicates rising costs to producers, increases in the PPI can foreshadow increases in the CPI.

Both the CPI and the PPI are calculated by the BLS. The Bureau of Economic Analysis (BEA) also calculates a measure of inflation known as the GDP deflator. The calculation of the GDP, or gross domestic product, deflator follows a different approach than that used to calculate the CPI and the PPI. Instead of using a fixed basket of items and measuring the price change of that fixed basket, the GDP deflator includes all of the components of the gross domestic product. Prices are taken from a base year and used to calculate what the GDP would have been in a given year if prices were identical to those in the base year.

Historical Trends in the Inflation Rate

Inflation, as measured by the CPI for 1947–2020, is displayed in Figure 3.10. The graph shows that for the past 70 years, inflation has been the norm. Although inflation dipped into negative territory several times, each period of negative inflation was short-lived. Also, you will notice that during the 1970s and early 1980s, inflation was abnormally high; the inflation rate remained above 5% for approximately a decade. This was also the only time period in which the US economy experienced double-digit inflation. By the mid-1980s, inflation had fallen below 5%, and it has remained below 5% for much of the past 35 years.

Figure 3.10 Rate of Inflation Measured by the Consumer Price Index, 1947–2020²

The Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL) is a measure of the average monthly change in the price for goods and services paid by urban consumers between any two time periods. It can also represent the buying habits of urban consumers. This particular index includes roughly 88% of the total population, accounting for wage earners, clerical workers, technical workers, self-employed workers, short-term workers, unemployed workers, retirees, and those not in the labor force.

The CPIs are based on prices for food, clothing, shelter, fuels, transportation fares, service fees (e.g., water and sewer service), and sales taxes. Prices are collected monthly from about 4,000 housing units and approximately 26,000 retail establishments across 87 urban areas. To calculate the index, price changes are averaged with weights representing their importance in the spending of a particular group. The index measures price changes (as a percent change) from a predetermined reference date. In addition to the original unadjusted index distributed, the BLS also releases a seasonally adjusted index. The unadjusted series reflects all factors that may influence a change in prices. However, it can be very useful to look at the seasonally adjusted CPI, which removes the effects of seasonal changes such as weather, the school year, production cycles, and holidays.

The CPI can be used to recognize periods of inflation and deflation. Significant increases in the CPI within a short time frame might indicate a period of inflation, and significant decreases in CPI within a short time frame might indicate a period of deflation. However, because the CPI includes volatile food and oil prices, it might not be a reliable measure of inflationary and deflationary periods. For more accurate detection, the core CPI, or CPILFESL—the CPIAUCSL minus food and energy—is often used. When using the CPI, please note that it is not applicable to all consumers and should not be used to determine relative living costs. Additionally, the CPI is a statistical measure vulnerable to sampling error because it is based on a sample of prices and not the complete average.

How Is GDP Measured?

GDP can be measured by adding up all of the items that are purchased in the economy. Purchases are divided into four broad expenditure categories: consumption spending, investment, government spending, and net exports. Consumption spending measures the items that households purchase, such as movie theater tickets, cups of coffee, and clothing. Consumption expenditure accounts for about two-thirds of the US GDP.⁴

Investment spending refers primarily to purchases by businesses. It is important to note that in this context, the term investment does not refer to purchasing stocks and bonds or trading financial securities. Instead, the term refers to purchasing new capital goods, such as buildings, machinery, and equipment, that will be used to produce other goods. Residential housing is also included in the investment-spending category, as are inventories. Products that producers make but do not sell this year (and so are not included in consumption spending) are included in this year’s GDP calculation through the investment component. The investment spending category is roughly 15% to 18% of the US GDP.

Government spending includes spending by federal, state, and local governments. Federal spending would include purchases of items such as a new military fighter jet and services such as the work of economists at the BLS. State governments purchase products such as concrete for a new highway and services such as the work of state troopers. Local governments purchase a variety of goods and services, such as books for the city library, playground equipment for the community park, and the services of public school teachers. In the United States, government spending accounts for nearly 20% of the GDP.

Some items that are produced in the United States are sold to individuals, businesses, or government entities outside of the United States. For example, a bottle of Tabasco sauce produced in Louisiana may be sold to a restaurant in Vietnam, or tires produced in Ohio may be sold to an auto producer in Mexico. Because these items represent production in the United States, these exports should be included in the US GDP. Conversely, some of the items that US consumers, businesses, and government entities purchase are not produced in the United States. A family may purchase maple syrup from Canada or a Samsung television that was produced in South Korea. A business may purchase a Toyota vehicle that was produced in Japan. These items are imported from other countries and represent production in the country of origin rather than the United States. Because we already counted these items when adding consumption, investment, and government spending, we must subtract the value of imports in our GDP calculation. Net exports equals exports from the United States minus imports from other countries. Including net exports in the GDP calculation adjusts for this international trade.

Historical Trends in GDP

US GDP over the past 70 years is represented by the blue line in Figure 3.12. At the turn of the millennium, the yearly GDP of the United States was approximately $10 trillion. By 2020, the GDP exceeded $21 trillion, indicating that the US economy had more than doubled in size in the first 20 years of the 21st century.⁵

Because GDP is the market value of all goods and services produced, it can increase either because more goods and services are being produced or because the market value of these goods and services is rising. If 100 cars were produced and sold for $30,000 each, that would contribute $3,000,000 to the GDP. If, instead, the cars were sold for $33,000 each, the same 100-car production would contribute $3,300,000 to the GDP. The $300,000 increase in GDP would be due simply to higher prices, or inflation.

Multiplying the current price of goods by the number of goods produced results in what is known as nominal GDP. In order to determine what the actual increase in production is, nominal GDP must be adjusted for inflation. This adjustment results in a calculation known as real GDP. To calculate real GDP, the amounts of goods and services produced are multiplied by the price levels in a base year. Thus, real GDP will rise only if more goods and services are being produced. The red line in Figure 3.12 represents the real GDP. Although its growth has not been as large as that of nominal GDP, real GDP has also grown significantly over the past 70 years.

Figure 3.12 Growth of the US GDP⁶ Gross domestic product (GDP), the featured measure of US output, is the market value of the goods and services produced by labor and property located in the United States. Real gross domestic product is the inflation-adjusted value of the goods and services produced by labor and property located in the United States. For more information, see the NIPA Handbook: Concepts and Methods of the US National Income and Product Accounts and the US Bureau of Economic Analysis.