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 indexShows 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 100Base Year Price

Composite Price IndexEach 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

Calculation of Simple Price Index X Weight

Euro

Food 8.50 12.75 X 100 = 150 X 35% = 52.50 8.50

Clothing & footwear

37.50 45 X 100 = 120 X 15% = 18 37.50

Other items

20.00 35 X 100 = 175 X 50% = 87.50 20

Price Index for the Current Year 158

Today………….

The Consumer Price IndexHow accurate is itHow it is constructedThe 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.

How accurate is the CPI???What are its limitations???

1. It is based on average spending patterns

2. Weights used apply in the base year only

3. Changes in quality of goods is not measured

4. New products on the Market are not included

5. Switching to cheaper brands is not measured

2007, Higher, Section B, Question 7A (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. Measure the rate of inflation2. Measure International

Competition3. Indexation of savings/investments4. Maintaining the real value of social

welfare payments5. Wage negotiations

Inflation……….

Causes of inflation Cost-push inflation Demand-pull inflation Government caused (induced) inflation

Effects of inflationHow to reduce inflationDeflation

How is it causedWhat 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. Lower Standard of living2. Purchasing power of money falls3. Increased wage demands4. Loss of competitiveness5. Loss of employment6. Borrowing encouraged7. Increased disparity between different

sectors8. A rise in government spending9. Production encouraged10. Uncertainty

Reducing inflation…………Use measures that take money out of the economy and reduce demand. Fiscal policy

Indirect taxes - VATDirect taxes – PAYESaving scheme - SSIA

Lower government spending National wage agreements Increased competition

Today………………. DeflationHow it is causedWhat it results in

DeflationIs 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.