iGCSE Economics

6.1 - Prices

Learning OutcomesWith regards to prices, candidates should be able to:• Describe how a consumer prices index/retail

prices index is calculated• Discuss the causes and consequences of Inflation• Discuss the causes and consequences of deflation

What is inflation?

Inflation is a general and sustained rise in the level of prices of goods and services

…. and an associated fall in the ‘real value’ of money

9 October 2008

Zimbabwe inflation hits

231 million per cent

A loaf of bread, which cost Z$500 at the

beginning of August, now costs

between Z$7,000 and Z$10,000

MEASURING INFLATION….

How is Inflation measured?

• Inflation is measured using a ‘Price Index’• The most common price indexes are Retail Price

Index (RPI) and Consumer Price Index (CPI)• They measure the changes in the cost of a basket

of commonly purchased retail goods and services

UK price inflation

Steps to calculating a Price Index

1. Identify the basket of goods and services purchased by the ‘typical’ family

2. Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets

3. Monitor how much the ‘typical’ family spends on each item in the basket

4. Weight the average price of each item by the proportion of household expenditure spent on it

5. Add up all the weighted average prices

6. Set the total weighted average price of the basket equal to 100

7. Repeat the monitoring of household spending patterns and prices

8. Compare the total weighted average price of the basket to base year to calculate the change in the price index

Step 1: Base Year - Identify the basket of goods and services purchased by the ‘typical’ family

• What types of products would this include?

• Why are only a ‘basket’ of goods chosen?

• Why might these goods change over time

Task – Read the article “CPI article 2012’

Step 2: Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets

• Why is it important to use different retailers?

Step 3: Monitor how much the ‘typical’ family spends on each item in the basket

• This is then used to work out what proportion of the household expenditure is spend on these goods.

Step 4: Weight the average price of each item by the proportion of household expenditure spent on it and add them up

• Calculate the weighted averages for Year 0• Calculate the total weighted price of the

basket in Year 0• Why is it important to consider the proportion

of household income?

Step 5: Set the total weighted average price of the basket equal to 100

Year 0 Cost of basket =$25 = 100

Step 7: Repeat the monitoring of household spending patterns and prices in subsequent years

• Calculate the new weighted averages for Year 1

• Calculate the total price of the basket in Year 1

Step 8: Compare the total weighted average price of the basket to base year to calculate the change in the price index

• Work out the change in price in Year 1 from the base year (Year 0)

• What would the price index be in Year 2 if the weighted average price for the basket of goods was calculated as $30?

Answer

1  Year 3 = $34.85; Year 4 = $37.80 2  Year 3 = 139.4; Year 4 = 151.2 3  51.2% 4  a Year 3 at 16.1% ; b Year 1 at 8%(inflation rate in the year 2 was at 11.11% and Year 4 at 8.46%)

Most countries compile a consumer price index (CPI) or a retail price index (RPI), or both

The methodology used for each index series is the same, but the products they include and the types of consumer they cover can differ. As a result they can provide slightly different measures of inflation

RPI vs CPI?

THE USES OF PRICE INDEXES

Uses of Price Indices

• As an economic indicator

• As a price deflator

• For indexation

As an economic indicator• A consumer or retail price index is a widely used

measure of price inflation and therefore a measure of changes in the costs

• Why would governments and businesses find this useful?

As a price deflator

• Rising prices reduce the purchasing power of wages, profits, pensions, savings, tax revenues etc.

• A price index is therefore used to calculate changes in their real values over time

For indexation

• Indexation involves increasing certain payments and values, such as state pensions and income tax thresholds, by the annual rate of increase in price inflation in order to keep their real value constant

THE CAUSES OF INFLATION…..

Demand-pull or Cost-push inflation?

Demand Pull Inflation• A demand-pull

inflation is caused by aggregate demand rising faster than the aggregate supply of goods and services

Cost –push inflation• A cost-push

inflation is caused by rising wages and other production costs.

Mini Whiteboard Challenge….Can you draw (next to each other) graphs to show demand-pull inflation and cost-push inflation?

Demand Pull Inflation

• What might cause AD to shift to the right?

• What would happen if supply was less elastic?

• What would happen if supply was more elastic?

• What will happen to the elasticity of supply in the long-run?

• At any given time what might determine the elasticity of supply?

Cost Push Inflation

• What sort of business costs might increase? (Hint: Look at the cartoon!)

• Why does this cause a shift of AS?

A rise in import prices may cause an imported inflation. Import prices may rise following a fall in the exchange rate of the importing country

Task:

• Read pages 144-145• Case study: Monetary inflation (answer all 4

questions)• Handout : Inflation Investigation (Internet based

research task)• Homework: Summary Questions: Q 1,2,3

THE CONSEQUENCES OF HIGH INFLATION (PRICE INSTABILITY)

Price inflation

• Low and stable price inflation can be beneficial for an economy:

It encourages consumers to buy goods and services sooner rather than later

It is more appealing for businesses to borrow money as interest rates are also low during periods of low inflation

Costs of Inflation on Households

Factory worker Low salary

PensionerFixed IncomeHas savings

CEOHigh IncomeHas a large amount of savings

How would each of these people be affected by high inflation, and why?

Effects of Inflation on Businesses

CostsExports Confidence

How would Inflation affect these aspects of business?

Consumer Demand Labour requirements

Task - Cost of inflation to an Economy

• In your books….. Write a paragraph for each of these macroeconomic objectives explaining the impact of high inflation

Economic Growth

Remember to use connectives

Unemployment Balance of Trade

Recap – Government Policies

• What are the usual government policies used to try to control inflation?

DEFLATION

What is deflation?

Disinflation refers to a slowdown in the rate at which prices are rising in general

but

deflation involves a continuous decline in the general level of prices in an economy

▼ Japanese inflation, 1970–2010 (% annual change in CPI)

So what’s so bad about falling prices?

• Increasing supply, competition, productivity and technological advance are good things for an economy and consumers, and have reduced the prices of many products over time, such as mobile phones, televisions, cars, holidays and clothing, in many countries

• However, when falling product prices become widespread and prolonged due to a slump in aggregate demand, the result is malign deflation

Consequences of Deflation

Consumers delay

spending waiting for prices to fall further

Firms cut their production and reduce the size of

their workforces

Stocks of unsold goods accumulate so firms cut their prices. Profits fall

Household incomes fall as unemployment rises,

reducing demand further

In addition,• the real cost of borrowing and public spending

rises• Firms cut investment and the government must

cut spending or raise taxes.• Eventually the economy goes into a deep

recession as demand, output, the demand for labour, and incomes continue to fall.

• Many firms may go out of business because they are unable to make any profit no matter how much they cut their prices.

Question…

• What can governments do in order to tackle deflation? (government policies)

Government policy and Deflation

• The first line of defense used by government is to cut interest rates

• Real Interest rate will be rising even if the nominal rate is Zero

• E.g. Imagine interest rates is Zero but prices are falling by 5% each year– A women borrows $1000 to be repaid in full after

12 months without interest– After 12 months, She can buy same amount of

products with $950, because of 5% deflation– Therefore, by paying $1000, she has actually paid

a real interest rate of 5%

Government policy and Deflation

• A government may also print more currency to pump more money into the economy

• Expansionary Fiscal Policy

Japanese inflation 1970-2010 (% annual change in CPI)

* All policies have been tried in Japan, yet the economy has continued to struggle with persistent deflation, slow growth and rising unemployment for many years* Japans problems are worsening because of shrinking and ageing population