Topic 3: Inflation Flashcards
What is Inflation?
-is the term used to describe a situation where the general or aggregate level of prices is rising
-inflation can be defined as a fall in the value of money because it erodes the purchasing power of money.
What is The Inflation Rate and how to calculate it?
- is the percent rate at which the price level changes from one period to the next
- Price level(this year) - Price level(last year) divided Price level(last year) x100
Name 4 degrees of inflation
- Creeping Inflation (1-4%): Not worrying
- Running inflation (10-20%): inflation is imposing significant costs on the economy and could easily start to creep higher.
- Hyper-Inflation (50%): Money ceases to function as a store of value, and it may not serve its other functions e.g. Romania, Zimbabwe
- Stagflation: situation in which a nation’s economy is characterized by relatively high price inflation and low (or negative) rates of economic growth.
What are the Causes of Inflation?
- Demand-Pull Inflation: total demand for goods and services is greater than the total supply of goods and services available for sale. Arises from any factor that increases aggregate (total) demand (AD) including: increases in exports, consumption, investment
- Cost-Push Inflation: Inflation that results from an initial increase in costs. Main sources are wage increases and increase in raw materials prices
What are the Problems Caused by Inflation?
1) Savings are discouraged
2) Exports become more expensive
3) Imports- If domestic inflation is rising faster than inflation in other countries, then imports become cheaper, home grown goods in trouble
4) Excessive Wage demands
5) Menu Costs
6) Shoe Leather Costs
7) Inconvenience
What are the Benefits of inflation?
- businesses encourage by rising prices
- moderate inflation increases risk taking
- Central bank targets a low but positive rate of inflation, thus avoiding the damage of hyperinflation on an economy and the threats of falling prices.
- Also enables them to use interest rate cuts to ward off a recession
What is Deflation?
- is a fall in the general level of prices (negative inflation).
- Contractionary fiscal policy can sometimes be labelled as ‘deflationary’
What is Disinflation?
Disinflation: a slowing of the inflation rate over a period of time.
What is the CPI (Consumer Price Index)?
- The CPI measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services
- It measures Price change. Its a price index, not a cost of living index
How to calculate CPI?
- Fix the Basket: Determine what prices are most important to the typical consumer.
- Find the Prices: Find the prices of each of the goods and services in the basket for each point in time
- Compute the basket’s cost: Use the data on prices to calculate the cost of the basket of goods and services at different times
- Choose a base year and compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared.
How is housing affected by the CPI?
The purchase of a house is an investment in a capital asset, purchased over a long period of time that usually appreciates in value.
It does not form part of consumption. House prices are excluded from the index.
The CPI does, however, include the current costs of housing, such as
mortgage interest costs
What is Harmonised Index of Consumer Prices (HICP)? and what is the difference from this and CPI?
- The expenditure weights and the items included in the basket of goods and services reflect the prevailing consumer patterns of each individual country.
- In order to allow for international price comparisons, Eurostat, in conjunction with the member states of the EU, has produced a Harmonised Index of Consumer Prices - HICP.
- The HICP excludes and the CPI includes: Mortgage interest, Building materials, Union subscriptions, Motor taxation, House insurance (dwelling), Non-service elements of motor and house insurance (contents).
What are the sources of biases within the CPI?
- Substitution Bias: Consumers switch to a less expensive alternative. CPI uses a fixed basket of goods so misses substitutions
- New Product Bias: The fixed basket of goods has a delay when incorporating new products that consumers purchase.
- Quality Bias: Prices may increase because the quality of the product is higher, not due to inflation.
- Outlet Bias: Purchases at lower priced stores like warehouses, discount stores, and online
What is another issue with CPI?
- Relevance of the CPI
- The CPI captures the price of an ‘average’ basket of goods.
- What does ‘average’ mean? May not be relevant for all individuals – we all have individual spending patterns.
What are the differences between CPI and GDP Deflator?
- The first is that GDP Deflator includes only domestic goods and not anything that is imported (C+I+G+X-M). The CPI includes anything bought by consumers including foreign goods.
- The second difference is that the GDP Deflator is a measure of the prices of all goods and services while the CPI is a measure of only goods bought by consumers.
