Unit 3: Inflation

Question 1

Inflation:

Answer 1

An increase in the average general price level, including the prices of the factors of production (land, labour, capital)
Inflation is measured in the % change in some price index from one year to another
Usually measured by the Consumer Price Index (CPI)

Question 2

Aggregate demand:

Answer 2

The total demand for all goods and services produced in the economy

Question 2

Aggregate Demand/Aggregate Supply

Answer 2

In unit one, we explored demand and supply in individual markets
Microeconomic level
Macroeconomics uses the Aggregate Demand/Aggregate Supply (AD/AS) model
works on the same principles, but includes all the goods and services produced within a nation within a given time period

Question 3

Aggregate supply:

Answer 3

The total supply of all goods and services produced in the economy

Question 4

Four factors causing inflation

Answer 4

Demand pull, cost push, imported cost push, structural

Question 5

1) Demand pull

Answer 5

There is an increase in aggregate demand (AD) when there is more full employment
This creates an excess demand
Expectations are important for this factor
If we expect prices to rise, we buy now, increasing demand, causing prices to rise

Question 6

2) Cost push

Answer 6

Anything that makes the supply curve shift left, indicating a decrease in supply
Increase in factors of production for business firms
- Tax increases (ie. sales tax)
- Wage increases
- Increase in energy costs
Makes it more expensive to produce goods

Question 7

3) Imported cost push

Answer 7

If the price of important imports increase, then the price of goods increase as a result
Example: If the price of OPEC oil increases, it will cause inflation for countries that import oil

Question 8

4) Structural

Answer 8

Occurs because of institutional arrangement in economy
Competition for products or labour does not exist (e.g. doctors, civil servants)
Assumes resources do not move quickly between institutions
- Easy for prices and wages to increase, but not easy for them to decrease

Shortages in expanding industries
On average, demand increases over time; therefore prices increase over time

Question 9

How is inflation measured?

Answer 9

Consumer Price Index (CPI): A price index that measures changes in the prices of consumer goods
In Canada, the Consumer Price Index is used to measure inflation
It is based on the cost of a basket of goods and services consumed by the “typical Canadian family”
typical Canadian family = Any size family, any income level, both urban and rural areas
Excludes those in communal colonies, prison inmates, and chronic care patients in hospitals & nursing homes

Question 10

Baskets of goods/services

Answer 10

Items that Canadians purchase are put into one of eight categories:
- Food
- Shelter
- Household Operations
- Clothing/Footwear
- Transportation
- Health/Personal Care
- Recreation/Education
- Alcohol/Tobacco
These items are then weighted to reflect their importance in a typical household
The pie chart to the right shows Canada’s CPI weights for 1992

Question 11

Calculation CPI

Answer 11

CPI can be used to compare changes in price of particular items or overall inflation from one year to another

Formula: P(inflation)= CPI(year 2) - CPI(year 1) / CPI (year 1) x100

Question 12

CPI Limitations

Answer 12

• Sample of population, not individuals
  Example: Could be a 10% increase due to higher tobacco prices, but you might not smoke
• Changing composition of ‘basket’ over time
  Stats Canada only surveys once every ten years, and revises weights
  Example: Cell phones are omnipresent now, but only used by certain professions 20 years ago
• Quality changes not included
  Example: a computer being sold today is very different in quality and price than a computer sold when the base year basket was created
  A great deal of what’s in the average Canadian household’s annual shopping cart is NOT in CPI “basket”
  Does not consider substitutes
  Example: generic rather than brand names

Question 13

Inflation consequences

Answer 13

Inflation redistributes income
Some benefit
- Borrowers - Since money is worth less, it becomes easier to pay back loans from previous years
Some lose
- Lenders - The money they get back from loans is worth less than it was when they lent it
- Unskilled workers - Since they get paid less, the increase represents a greater percentage of their wage
- Non-union workers - don’t negotiate pay as often as union workers (every 2-3 years)
Unions use indexing to adjust wages in negotiations
- Fixed income earners (pensioners) - Income stays the same as cost of living increases