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 Index
How 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 CPI1. 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.