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Revision: The price level (The consumer price index & inflation) Inflation Definition Causes of inflation Cost-push inflation Demand-pull inflation Government caused (induced) inflation Effects of inflation How to reduce inflation Deflation How is it caused What it results in Measuring the changes in prices Simple Price Index Composition Price Index Consumer Price Index How accurate it is? Uses of the CPI Inflation…… Is defined as the steady and persistent increase in the general level of prices This results in the value of money of money falling and the cost of living increasing Therefore one cannot buy the same quantity of goods and services they could have in the previous year Simple price index Shows the percentage change in the price of the good over a specific time period It is an unweighted price index as it does not take into account the fraction of income spent on the good. 3 steps involved New Price X 100 Base Year Price Composite Price Index Each good is assigned a “weight” which reflects the percentage of income which is spent on it. It is a weighted price index and shows the effect to the overall cost of living due to changes in the price of goods. 6 steps involved Workbook, page 107, question 10 For a composite (weighted) price index covering the three types of expenditure given in the following table, calculate the index for the current year. The base year value is 100. Show your workings. Category % of income spent on the item Price of item in base year (Euro) Price of item in current year (Euro) Food 35 8.50 12.75 Clothing and footwear 15 37.50 45.00 Other items 50 20.00 35.00 100 Solution…… Category Prices of item(s) Base Year Euro Calculation of Simple Price Index X Weight Food 8.50 12.75 X 100 8.50 = 150 X 35% = 52.50 Clothing & footwear 37.50 45 X 100 37.50 = 120 X 15% = Other items 20.00 35 X 100 20 = 175 X 50% = 87.50 Price Index for the Current Year 18 158 Today…………. The Consumer Price Index How accurate is it How it is constructed The economic uses of the CPI The CPI The Consumer Price Index It measures the change in the average level of prices paid by all private household on consumer goods/services. It began in January 1997, it is compiled on a monthly basis covering over a thousand items. The Household budget survey is carried out every five to seven years to find out the fraction of income spent on each items. This survey is carried out to get accurate details of consumers spending patterns. 1. 2. 3. 4. 5. How accurate is the CPI??? What are its limitations??? It is based on average spending patterns Weights used apply in the base year only Changes in quality of goods is not measured New products on the Market are not included Switching to cheaper brands is not measured 2007, Higher, Section B, Question 7 A (ii) Explain how a Consumer Price Index is conducted? 1. It is based on the “National Average Family Shopping Basket” Those items which the average Irish family buys frequently and in large quantities are included. 2. Expenditure patterns are divided into various categories The CPI contains various categories of expenditure; food, alcohol, clothing & footwear, housing, transport etc. 3. Calculation of “Weight” The weight is the fraction of income which is spent on each category of expenditure, obtained through the Household Budget Survey, only takes place every 5 to 7 years. 4. Prices in Base Year Chosen The average cost of the items is equal to 100 e.g. – milk 40%, bread 35% and apples 25%. This makes it easier to compare in future years. 5. Prices in Current Year Determined The current prices of each item are collected from a panel of retail and service outlets in various locations throughout the country. Economic uses of a CPI 1. 2. 3. 4. 5. Measure the rate of inflation Measure International Competition Indexation of savings/investments Maintaining the real value of social welfare payments Wage negotiations Inflation………. Causes of inflation Cost-push inflation Demand-pull inflation Government caused (induced) inflation Effects of inflation How to reduce inflation Deflation How is it caused What it results in Causes of inflation………. Cost-push Demand-pull Government induced Cost push inflation……. Any increase in the general level of prices due to an increase in the costs of production/costs of inputs faced by the employer. This can be due to……… Increased wage demands due to the minimum wage or social partnership agreements Increased prices for raw materials, e.g. – oil Increased costs of production e.g. – utility charges, rent costs, insurance costs. Demand pull inflation………. Is when the economy cannot produce enough goods and services to meet the demand of citizens. Too much money is said to be “chasing” too few good. Therefore demand is greater than supply and producers see an opportunity to increase prices. This can be due to……………. Goods cannot be manufactured/imported quick enough to meet new demand Unexpected increase in consumer confidence Firms with monopoly power take advantage of their position by raising prices Government induced inflation………. A rise in prices as a result of some action by the government. This can be due to……… An increase in indirect taxes, e.g. – VAT A decrease in direct taxes, e.g. – PAYE can cause demand pull inflation as [people will have more money to spend An increase in lending by the banks Effects of inflation………. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Lower Standard of living Purchasing power of money falls Increased wage demands Loss of competitiveness Loss of employment Borrowing encouraged Increased disparity between different sectors A rise in government spending Production encouraged Uncertainty Reducing inflation………… Use measures that take money out of the economy and reduce demand. Fiscal policy Indirect taxes - VAT Direct taxes – PAYE Saving scheme - SSIA Lower government spending National wage agreements Increased competition Today………………. Deflation How it is caused What it results in Deflation Is negative inflation – Prices are going down rather than up. Deflation can be caused by………. Over supply relative to demand, e.g. – more hotel rooms than there are people to stay in them A sudden drop in demand or investment or government spending or all three, e.g. – in a recession Persistent unfavorable balance of payments – more money leaving the country on imports than coming in on exports Results of deflation………. An increase in the purchasing power of money - Employers use this to justify wage cuts and the government uses it to justify cuts in social welfare. The government can save money on capital projects – cost of construction and raw materials falls. Increased national competitiveness – provided that Irish prices fall by more than competing countries’ prices do.