INFLATION & THE CONSUMER PRICE INDEX (CPI) Economics Indicators INFLATION & THE CONSUMER PRICE INDEX (CPI)

What is Inflation? Inflation A significant rise in prices and costs that results in the decline in the purchasing power of a currency. An increase in the price of just one good or service is not inflation. Economists have identified two main forms of inflation: Cost Push & Demand Pull Inflation.

Demand Pull Inflation If there is an increase in demand from households, firms, government, aggregate demand (total demand) can be forced upwards and the price level pulled up accordingly. High levels of consumer demand may occur when employment is strong (low unemployment) and incomes are rising.

Cost Push Inflation An across the board increase in producers costs of production can cause cost push inflation. What would cause cost-push inflation?? eg. Wage rises, a rise in the price of imported oil (transport companies) and an increase in interest rates Labour costs usually represent the largest component of production costs and can contribute significantly to inflationary pressures during a boom period.

What level of inflation is acceptable for a developed country? At first, it would be desirable to want a very low rate of inflation for a country. However, very low rates of inflation (less than 1%) indicate low levels of economic demand and low GDP growth. An inflation rate of 2 to 3% is considered desirable for most developed economies as a sign of a healthy economy. However, there are exceptions like Japan. An inflation rate of 5% or more for a developed country is generally too high and it would be a sign of an overheating (growing too fast) economy – cost push inflation would be a problem.

What level of inflation is acceptable for a developing country? A developing country, may have a higher inflation rate than a developed country, because price stability may be less important than economic growth. An inflation rate of 5 to 10% may be acceptable, if high (GDP) growth is being achieved. However, if inflation is between 5 to 10% and economic growth is relatively low, then policy makers are failing to achieve the most optimum use of resources.

Inflation - Exercise Go to www.economist.com Click on economics, and then market & data, and then output, jobs etc. List three countries with the highest inflation rate in the developed world. List three countries with the highest inflation rate in the developing world? A inflation rate of between 2 to 3% is considered a healthy range for a developed economy with moderate growth rates. How many countries are in this category?

HOW TO MEASURE INFLATION: PRICE INDICES The main function of a price index is to give a generalized and simplified view of price changes by summarizing in one figure, the general movements in prices of a number of a number of commodities.

HOW TO MEASURE INFLATION: COMPILING A PRICE INDEX Selection of a Regimen The regimen is the group or basket of commodities whose price changes are to be summarized in the price index. Collection of Accurate Prices

HOW TO MEASURE INFLATION: COMPILING A PRICE INDEX Selection of a Base Year or Period It is necessary to select a period as a standard with which prices in other periods can be compared. This should be a normal period (not a war period or period of high inflation or a recession). The aggregate expenditure on the regimen in the base period is denoted by the index number 100. The index number for the following years is then expressed as percentage.

HOW TO MEASURE INFLATION: COMPILING A PRICE INDEX Weighting the Items This is an attempt to assess the relative importance of expenditure of items included in the regimen. Eg. Milk would be given greater weighting than Jeans, because it is purchased more often and is more important to the majority of the population. In creating a indice, weight can simply return to the frequency of purchase.

HOW TO MEASURE INFLATION PRICE INDICE - EXAMPLE Product Weight Price 2007 Expenditure 2008 Quiksilver Boardshorts 1 $49 49 $55 55 Pauls Milk 2 Litre 30 $3.10 93 $3.25 97.5 Top 10 CD (Target) 3 $20.50 61.5 $21.15 63.45 Train Ticket (Metrorail) 20 $3.95 79 $4.05 81 282.5 296.95 TASK: Using the above information calculate the inflation rate for 2008

HOW TO MEASURE INFLATION PRICE INDICE - EXERCISES Formula CPI = (296.95/282.5) x 100 = 5.12% New weighted Total Price x 100 Old Weighted Total Price

What is the inflation rate in the island nation of Isla Bonita? Product Weight Price 2012 Expenditure 2013 Swimming Suit 1 $35 $40 1 Litre Orange Juice 25 $1.25 $1.35 1 Bus Ticket 15 $2.25 $2.30 Rent (average apartment) 10000 11000 TASK: Using the above information calculate the inflation rate at end of 2013

The Consumer Price Index (CPI) A Key Economic Indicator Most countries in the world publish a CPI which is a key economic indicator. The consumer price index is sophisticated price indice. Date is published monthly. The CPI includes a range of goods and services. This includes the cost to rent average home, the price of bus tickets, and a range of food and beverages. Housing has the strongest weighting in most CPI calculations. In many countries, the CPI also includes items such as tobacco, which some economists believe should be excluded.

Problems with the CPI Often the CPI Index is based only on price changes in largest cities in the country. The CPI will often not measure prices changes in rural or country areas. The CPI may include items like tobacco and alcohol, which are not purchased by all consumers. The CPI does not consider the buying habits of consumers on very low or very high incomes.

Deflation During periods of economic contraction (negative GDP), an economy may experience deflation – prices on average start falling. Alternatively, a country may have positive GDP growth generated by exports sales, but still have very low levels of demand in the domestic economy. This low level of demand in the domestic economy will force prices down. This is the problem in Japan. Japan has suffered from several periods of deflation in the last 15 years.

DEFLATION Definition Deflation is defined as a persistent fall in the average price level of prices in the economy. Prices are below the original base year 100 (eg: 98) There are two broad explanations for a fall in the price level, and economists have used these to categorise – “good deflation” and “bad deflation”

DEFLATION Good Deflation Good deflation is achieved from improvements in the supply side of the economy and or increased productivity. An improvement in technology could also result in prices falling. An improvement in labour productivity could also result in prices falling.

DEFLATION Bad Deflation Bad deflation finds it source in the demand side of the economy. Very low levels of demand (often in experienced during a very severe recession) will result in prices falling. If businesses cannot sell their product (due to low demand) they will be forced to sell their goods and services at lower prices in order to survive.

DEFLATION Good Deflation vs Bad Deflation Both causes of deflation result in a fall in the price level, but we might say that the first is positive because it results in an increase in real output and fall in unemployment. The second is negative, because it results in a fall in real output and a rise in unemployment.

DEFLATION VS DISINFLATION It is very important that you do not confuse deflation with a falling rate of inflation, which might be referred to as disinflation. Disinflation – a decline in inflation. Year 1: 100 (Base year) Year 2: 110. (10% inflation) Year 3: 112. (2% inflation) Disinflation has occurred between year 2 & year 3.

THE UNDERLYING INFLATION RATE Instead of just quoting the standard or headline CPI figure, some economists cite the underlying CPI rate, as a more accurate reflection of price changes. The underlying CPI rate is an attempt to identify the price changes resulting from real demand and supply forces at work in the domestic economy and not price changes caused by temporary institutional or external (international) factors. The underlying CPI measure excludes seasonal factors, petrol prices and government and financial charges which are included in the headline rate.