Download Revision, CPI and Inflation

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.