Chapter 6Chapter 6

Inflation and PricesInflation and Prices

Prices IndicesPrices Indices

Simple Price IndexSimple Price Index This is a statistical table This is a statistical table

constructed to measure changes constructed to measure changes in price levels of one commodity in price levels of one commodity only.only.

Current PriceCurrent Price Formula = __________ x 100Formula = __________ x 100

Price at Base PeriodPrice at Base Period

Construction of Simple Price Construction of Simple Price IndexIndex

Choose Base periodChoose Base period Price of that commodity in base Price of that commodity in base

period = 100period = 100 Express the prices in all the Express the prices in all the

subsequent periods as a % of subsequent periods as a % of the price in the base periodthe price in the base period

AdvantagesAdvantages

Make Make comparisons at a comparisons at a glance without glance without detailed detailed calculationscalculations

Make trends Make trends more evident more evident than a list of than a list of commodity pricescommodity prices

DisadvantagesDisadvantages

Because a SPI attaches equal Because a SPI attaches equal importance to each product, it importance to each product, it cannot accurately reflect cannot accurately reflect changes in the cost of livingchanges in the cost of living

Composite Price IndexComposite Price Index

Measures changes in the prices of Measures changes in the prices of several commodities.several commodities.

More difficult to construct because it More difficult to construct because it attempts to show with one set of attempts to show with one set of figures, changes in the prices of figures, changes in the prices of several commoditiesseveral commodities

CPI is one which does not give equal CPI is one which does not give equal importance to each good. Each good importance to each good. Each good is given a weight which reflects the is given a weight which reflects the % change of income which is spent % change of income which is spent on it.on it.

Construction of Composite Construction of Composite Price IndexPrice Index

1)1) Choose a base periodChoose a base period

2)2) Construct a SI for each commodity Construct a SI for each commodity to be incorporated into the to be incorporated into the composite indexcomposite index

3)3) Attach weight or degree of Attach weight or degree of importance to each commodityimportance to each commodity

4)4) Multiply each SI by its weight Multiply each SI by its weight

5)5) Add the result to form a composite Add the result to form a composite indexindex

Limitations of Price IndicesLimitations of Price Indices

1.1. Based on Based on sample groupssample groups of consumers, of consumers, retailers & producers – may be retailers & producers – may be unrepresentativeunrepresentative of the whole of the whole communitycommunity

2.2. Product who’s Product who’s popularity is decliningpopularity is declining may still be included in the price indexmay still be included in the price index

3.3. A A new productnew product introduced who’s introduced who’s popularity is increasingpopularity is increasing may not be may not be included in the price indexincluded in the price index

Limitations of Price IndicesLimitations of Price Indices

1.1. The The weight weight attached to a product attached to a product may may changechange as the expenditure as the expenditure patterns of patterns of consumers change.consumers change.

2.2. Price index Price index ignores ignores any any changes changes in in thethe qualityquality of the products it of the products it

coverscovers. .

Consumer Price IndexConsumer Price Index

A composite price index A composite price index measures changes in the cost of measures changes in the cost of living by reflecting changes in living by reflecting changes in the prices of ten different groups the prices of ten different groups of commodities which figure of commodities which figure prominently in the monthly prominently in the monthly expenditure of the average Irish expenditure of the average Irish household.household.

How is CPI calculated?How is CPI calculated?

Index includes only Index includes only items the average items the average Irish family purchases Irish family purchases frequently and in frequently and in large quantities.large quantities. E.g. ‘national average E.g. ‘national average

family shopping basketfamily shopping basket Gathered by CSO-Gathered by CSO-

household budget household budget inquiryinquiry

How is CPI calculated?How is CPI calculated?

Presently contains 11 categories of Presently contains 11 categories of expenditureexpenditure

Average cost of all the items in a Average cost of all the items in a base year = 100 and subsequent base year = 100 and subsequent increases in the average price of all increases in the average price of all these items are related to that figure these items are related to that figure of 100.of 100.

The weight attached to each The weight attached to each category is obtained from the category is obtained from the household budget inquiry.household budget inquiry.

Importance of the CPIImportance of the CPI

1.1. Trade UnionsTrade Unions1.1. National wage agreement negotiations as a National wage agreement negotiations as a

claim for an increase in wages.claim for an increase in wages.

2.2. Official indication of inflation rateOfficial indication of inflation rate3.3. One of the main indicators of a country’s One of the main indicators of a country’s

economic performance.economic performance.4.4. Enables comparisons to be made with Enables comparisons to be made with

foreign countries relating to price foreign countries relating to price competitiveness of our goods on foreign competitiveness of our goods on foreign markets.markets.

5.5. Provides a base for indexation of savingsProvides a base for indexation of savings

Disadvantages of CPIDisadvantages of CPI- inaccurate indicator of changes - inaccurate indicator of changes in the cost of living?in the cost of living?1.1. Limited scopeLimited scope

1.1. The average family spends its monthly The average family spends its monthly income on more than 11 different items, only income on more than 11 different items, only some are included in the indexsome are included in the index

2.2. Differences in lifestylesDifferences in lifestyles1.1. Urban v’s rural, an increase in the cost of Urban v’s rural, an increase in the cost of

items may affect only certain people items may affect only certain people depending on their lifestyles. depending on their lifestyles.

3.3. Consumer trendsConsumer trends1.1. CPI does not include all new items and some CPI does not include all new items and some

items may be very important in the average items may be very important in the average family household.family household.

Disadvantages of CPIDisadvantages of CPI- inaccurate indicator of changes - inaccurate indicator of changes in the cost of living?in the cost of living?1.1. Overstates cost of livingOverstates cost of living

1.1. If prices rise there will be a If prices rise there will be a substitution to cheaper goodssubstitution to cheaper goods

2.2. Base yearBase year1.1. Needs to be constantly updatedNeeds to be constantly updated

3.3. Quality changesQuality changes1.1. Doesn’t reflect quality changes for Doesn’t reflect quality changes for

items- compensate for price increasesitems- compensate for price increases

4.4. Household Budget inquiryHousehold Budget inquiry1.1. Needs to be accurateNeeds to be accurate

Constant Tax Price IndexConstant Tax Price Index

A price index measures A price index measures changes in the prices of changes in the prices of goods, but excludes goods, but excludes price changes which are price changes which are caused by changes in caused by changes in indirect taxes. indirect taxes.

When used with the CPI, When used with the CPI, it shows how much of it shows how much of the overall price change the overall price change in any period is due to in any period is due to indirect taxes and how indirect taxes and how much is due to all other much is due to all other factors.factors.

GNP DeflatorGNP Deflator

GNP at current prices x 100GNP at current prices x 100GNP at constant pricesGNP at constant prices

Measure of overall price Measure of overall price changes of the economychanges of the economy

InflationInflation

Inflation is a Inflation is a steady and steady and persistent persistent increase in the increase in the general level of general level of pricesprices

Types of inflationTypes of inflation

1.1. Creeping Creeping inflationinflation

1.1. Low steady rate Low steady rate of annual of annual increase in P. increase in P. levelslevels

2.2. Rapid inflationRapid inflation1.1. Significant Significant

annual increase annual increase in P. levelsin P. levels

3.3. Hyper-inflationHyper-inflation1.1. Huge increase Huge increase

in P. levels. in P. levels. Erodes PP of Erodes PP of moneymoney

Causes of InflationCauses of Inflation

1.1. Demand Pull Demand Pull inflationinflation

2.2. Cost push Cost push inflationinflation

1.Demand Pull Inflation1.Demand Pull Inflation

Total Demand > Total SupplyTotal Demand > Total Supply Def: occurs when the economy Def: occurs when the economy

cannot produce enough goods to cannot produce enough goods to meets the demands of its citizensmeets the demands of its citizens

Sellers increase profits by increasing Sellers increase profits by increasing pricesprices

The spending power of consumers The spending power of consumers increases faster than the production increases faster than the production of goods and services.of goods and services.

incomes, incomes, outputoutput Productivity = demand pull inflationProductivity = demand pull inflation

Demand-Pull InflationDemand-Pull Inflation

2. Cost push inflation2. Cost push inflation

Def: occurs when the selling prices Def: occurs when the selling prices of goods/services are increased to of goods/services are increased to compensate the producer for an compensate the producer for an increase in the costs of productionincrease in the costs of production

Labour, land, capital and enterprise Labour, land, capital and enterprise costs costs

1.1. Wage increasesWage increases

2.2. TaxationTaxation

3.3. Import PricesImport Prices

Cost push inflationCost push inflation

Wage increaseWage increase Labour costs Labour costs therefore prices therefore prices

so that profits maintainedso that profits maintained TaxationTaxation

Direct tax/indirect taxDirect tax/indirect tax directly/indirectly increases directly/indirectly increases pricesprices

Import pricesImport prices Price of raw materials Price of raw materials prices prices

Cost push inflationCost push inflation

Class Work!!!!Class Work!!!!

In groups of 3-4 In groups of 3-4

Task: Task:

…………discuss what outcomes could discuss what outcomes could arise in the country if inflation arise in the country if inflation increased dramatically…..increased dramatically…..

Come up with 4 ideas!!!!Come up with 4 ideas!!!!

Problems caused by inflationProblems caused by inflation

1.1. Savings are discouragedSavings are discouraged1.1. If prices rise, money loses some If prices rise, money loses some

of its purchasing power.of its purchasing power.

2.2. People tend to spend their People tend to spend their money rather than save it. money rather than save it.

3.3. ConsumptionConsumption and savings and savings4.4. If savingsIf savings, less funds available , less funds available

for lending therefore for lending therefore investmentinvestment

5.5. Exports become dearerExports become dearer

2.2. Exports become dearerExports become dearer1.1. Prices of a country’s exports Prices of a country’s exports

and they become less and they become less competitive on foreign markets.competitive on foreign markets.

2.2. BOP deficit and adversely affect BOP deficit and adversely affect domestic employmentdomestic employment

3.3. ImportsImports1.1. Imports will become relatively Imports will become relatively

cheaper than domestically cheaper than domestically produced productsproduced products

2.2. This may replace home This may replace home produced goodsproduced goods

3.3. BOP problems and loss of BOP problems and loss of domestic employment.domestic employment.

4.4. The economically weaker The economically weaker sections of society suffersections of society suffer

1.1. People with fixed low incomes People with fixed low incomes experience a fall in their real incomesexperience a fall in their real incomes

2.2. Prices may rise and erodes real Prices may rise and erodes real incomesincomes

5.5. Excessive wage demandsExcessive wage demands1.1. Trade unions may seek wage Trade unions may seek wage

increases for its members due to increases for its members due to increasing prices, this in turn might increasing prices, this in turn might force inflation rate higher (cost-push)force inflation rate higher (cost-push)

6.6. Speculation is encouragedSpeculation is encouraged1.1. Value of assets Value of assets investments in investments in

landland money moved into speculative money moved into speculative investmentsinvestments

7.7. Borrowing is encouragedBorrowing is encouraged7.7. Real cost of borrowing tend to be Real cost of borrowing tend to be

lowlow8.8. Borrowing rate maybe less than Borrowing rate maybe less than

the current inflation ratethe current inflation rate9.9. Real value of repayments Real value of repayments

decreases and financial burden decreases and financial burden of borrowing is less severe of borrowing is less severe (demand-pull)(demand-pull)

8.8. Confidence in the currency Confidence in the currency is underminedis undermined

7.7. Money loses its value rapidly Money loses its value rapidly and people tend to lose and people tend to lose confidence in their currencyconfidence in their currency

Class work!!Class work!!

In groups of 3-4In groups of 3-4

Discuss some ways or methods to Discuss some ways or methods to reduce inflationreduce inflation

4 minutes!!!!4 minutes!!!!

Curbing InflationCurbing InflationReduced Aggregate DemandReduced Aggregate Demand

Demand-pull = aggregate Demand-pull = aggregate demand exceeds aggregate demand exceeds aggregate supply.supply.

Aggregate demand = C+I+G+Aggregate demand = C+I+G+(X-M)(X-M)

Policies that reduce C,I,G will Policies that reduce C,I,G will reduce demand-pullreduce demand-pull

a)a) Reducing ConsumptionReducing Consumptiona)a) Higher taxation – consumer have Higher taxation – consumer have

less disposable income to spend less disposable income to spend therefore demand fallstherefore demand falls

b)b) Credit squeeze – restricting Credit squeeze – restricting credit and raising interest rates credit and raising interest rates will discourage borrowing and will discourage borrowing and lessen the purchasing power of lessen the purchasing power of consumersconsumers

c)c) Incomes Policy – restricting the Incomes Policy – restricting the size of wage increases ensures size of wage increases ensures that pur.power of consumers that pur.power of consumers does not increase too rapidlydoes not increase too rapidly

b)b) Reducing InvestmentReducing Investmenta)a) In practice this is not used as it In practice this is not used as it

can be the main source of can be the main source of employment creation and it employment creation and it forms the basis of the future forms the basis of the future wealth creating capacity.wealth creating capacity.

Therefore the gov tackles demand Therefore the gov tackles demand pull by reducing consumption pull by reducing consumption and gov spendingand gov spending

Reduce investment

c)c) Reducing Gov. SpendingReducing Gov. Spendinga)a) The gov. can reduce the The gov. can reduce the

pur.power of consumers & pur.power of consumers & decrease aggregate demand by decrease aggregate demand by reducing gov. spending.reducing gov. spending.

b)b) Gov. can reduce expenditure by Gov. can reduce expenditure by reducing: reducing:

a)a) Volume/quality of public servicesVolume/quality of public services

b)b) The no. of employees in public The no. of employees in public sectorsector

c)c) Social welfare paymentsSocial welfare payments

d)d) Capital expenditure programsCapital expenditure programs

This may lead to considerable This may lead to considerable opposition from sectors of the opposition from sectors of the economy.economy.

This may cause unemployment, This may cause unemployment, decline in (social) welfare and a decline in (social) welfare and a decline in public investment.decline in public investment.

Quick and efficientQuick and efficient Not very popular approachNot very popular approach

Gov. want to be re-electedGov. want to be re-elected May loose votesMay loose votes

Controlling cost push factors:Controlling cost push factors:restrain the cost push influencesrestrain the cost push influences

a)a) Wage restraintWage restraint – wage – wage controlscontrols

Principal causes of inflationPrincipal causes of inflation Indicative planningIndicative planning – Gov, – Gov,

employers & trade unions employers & trade unions agree on rate of pay increases agree on rate of pay increases for coming year. for coming year.

Voluntary agreementsVoluntary agreements

Prices and Incomes Policy –Prices and Incomes Policy – policies to control price policies to control price increase & limiting wage increase & limiting wage increasesincreases

Statutory wage controls – Statutory wage controls – legal ban against wage legal ban against wage increases/increases over a increases/increases over a certain %. certain %.

Gov reluctant to do this Gov reluctant to do this

Very usual it only takes place Very usual it only takes place when there are serious when there are serious economic conditionseconomic conditions

b)b) Controlling other costs – Controlling other costs – other factors that can cause other factors that can cause cost push inflationcost push inflation

Interest rates – Interest rates – Gov can Gov can influence the level of domestic influence the level of domestic interest ratesinterest rates

Taxes – Taxes – reduce direct & reduce direct & indirect Tax would lessen the indirect Tax would lessen the costs to businessescosts to businesses

c)c) Productivity increases – Productivity increases –

wage increase may not cause wage increase may not cause cost push inflation. cost push inflation.

If the total output increases by If the total output increases by the same % as the wages then the same % as the wages then unit labour costs remain unit labour costs remain unchangedunchanged

Increasing employee productivity Increasing employee productivity can be difficult to achieve as can be difficult to achieve as employees may resist the concept employees may resist the concept of greater work.of greater work.

Difficult to measure productivity in Difficult to measure productivity in the services sectorthe services sector

Increases in productivity are not Increases in productivity are not realisticrealistic

Increased productivity and output Increased productivity and output is of no benefit to an employer is of no benefit to an employer who cannot sell more.who cannot sell more.

Equation of Exchange- Equation of Exchange- Irving Irving FisherFisher

This model allows us to see the This model allows us to see the effect that the quantity of money effect that the quantity of money has on the economy. has on the economy.

To do this we must see how the To do this we must see how the quantity of money is related to quantity of money is related to price and incomes.price and incomes.

The Quantity Theory of Money The Quantity Theory of Money and Inflationand Inflation

Consumers need money to purchase goods and services. The quantity of money is related to the number of euros

exchanged in transactions. The link between transactions

and money is expressed in the

quantity equation.

Money*Velocity=Price*Quantity (transactions)

On the left hand side, “M” is the quantity of money, “V” is

the velocity of money, and “V•M” is essentially a measure

of how the money is used to make transactions.

M*V=P*Q

M*V=GNP On the right hand side, “Q” is the total number of transactions during some period of time, “P”

is the price of a typical transaction, and “P•Q” is the

number of euros exchanged in a year.

Rearranging the quantity equation yields velocity to be…

V=PQ/M

M*V=P*Y

V=GNP/M V is defined as the avg. number

of times per year the nation’s stock of money is spent on purchasing the nation’s output or GNP

Assume that V and Q are fairly Assume that V and Q are fairly constant over a certain timeconstant over a certain time

Therefore M=PTherefore M=P Changes in money supply have Changes in money supply have

a direct effect on the price level.a direct effect on the price level.

Wage/Price spiralWage/Price spiral When wage costs increase When wage costs increase

producers and sellers must increase producers and sellers must increase their prices to maintain their profitstheir prices to maintain their profits

A general increase in the level of A general increase in the level of prices leads workers to demand prices leads workers to demand further wage increases so as to further wage increases so as to restore real income.restore real income.

Therefore Therefore wages leads to wages leads to prices prices &in turn wages&in turn wages prices prices

Prices/incomes policy is one anti-Prices/incomes policy is one anti-inflammatory to control increases in inflammatory to control increases in wages & priceswages & prices

Wage spiral

DeflationDeflation

Opposite of inflationOpposite of inflation Aggregate demand < total Aggregate demand < total

output. This leads to falling output. This leads to falling pricesprices

Deflationary policies are policies Deflationary policies are policies that depress aggregate demandthat depress aggregate demand

(see notes on reducing (see notes on reducing consumption, limiting wage consumption, limiting wage increases and gov. spending)increases and gov. spending)

Class work!!!Class work!!!

In groups of 3-4In groups of 3-4

What type of inflation do you think What type of inflation do you think Ireland has and what has Ireland has and what has caused this?caused this?

4mins4mins

Inflation in IrelandInflation in Ireland

In mid 1990’s our low inflation rate In mid 1990’s our low inflation rate increased our export performance increased our export performance but as economic growth soared but as economic growth soared inflationary pressures built up.inflationary pressures built up.

2000 Ireland's Inflation rate was very 2000 Ireland's Inflation rate was very high and the EU formally high and the EU formally reprimanded Ireland to curtail the reprimanded Ireland to curtail the level of demand in the economy.level of demand in the economy.

Irish Inflation nowIrish Inflation now

Irish Consumer Inflation falls Irish Consumer Inflation falls sharply to 2.5% in November; sharply to 2.5% in November; Ireland is on path to deflation in Ireland is on path to deflation in 2009 for first time since 19462009 for first time since 1946By Finfacts TeamBy Finfacts TeamDec 11, 2008 - 12:56:13 PMDec 11, 2008 - 12:56:13 PM