Chapter 6 Inflation and Prices Inflation and Prices

Prices Indices Simple Price Index Simple Price Index This is a statistical table constructed to measure changes in price levels of one commodity only. This is a statistical table constructed to measure changes in price levels of one commodity only. Current Price Current Price  Formula = __________ x 100 Price at Base Period

Construction of Simple Price Index Choose Base period Choose Base period Price of that commodity in base period = 100 Price of that commodity in base period = 100 Express the prices in all the subsequent periods as a % of the price in the base period Express the prices in all the subsequent periods as a % of the price in the base period

Advantages Make comparisons at a glance without detailed calculations Make comparisons at a glance without detailed calculations Make trends more evident than a list of commodity prices Make trends more evident than a list of commodity prices

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

Composite Price Index Measures changes in the prices of several commodities. Measures changes in the prices of several commodities. More difficult to construct because it attempts to show with one set of figures, changes in the prices of several commodities More difficult to construct because it attempts to show with one set of figures, changes in the prices of several commodities CPI is one which does not give equal importance to each good. Each good is given a weight which reflects the % change of income which is spent on it. CPI is one which does not give equal importance to each good. Each good is given a weight which reflects the % change of income which is spent on it.

Construction of Composite Price Index 1) Choose a base period 2) Construct a SI for each commodity to be incorporated into the composite index 3) Attach weight or degree of importance to each commodity 4) Multiply each SI by its weight 5) Add the result to form a composite index

Limitations of Price Indices 1. Based on sample groups of consumers, retailers & producers – may be unrepresentative of the whole community 2. Product who’s popularity is declining may still be included in the price index 3. A new product introduced who’s popularity is increasing may not be included in the price index

Limitations of Price Indices 1. The weight attached to a product may change as the expenditure patterns of consumers change. 2. Price index ignores any changes in the quality of the products it covers.

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

How is CPI calculated? Index includes only items the average Irish family purchases frequently and in large quantities. Index includes only items the average Irish family purchases frequently and in large quantities. E.g. ‘national average family shopping basket E.g. ‘national average family shopping basket Gathered by CSO- household budget inquiry Gathered by CSO- household budget inquiry

How is CPI calculated? Presently contains 11 categories of expenditure Presently contains 11 categories of expenditure Average cost of all the items in a base year = 100 and subsequent increases in the average price of all these items are related to that figure of 100. Average cost of all the items in a base year = 100 and subsequent increases in the average price of all these items are related to that figure of 100. The weight attached to each category is obtained from the household budget inquiry. The weight attached to each category is obtained from the household budget inquiry.

Importance of the CPI 1. Trade Unions 1. National wage agreement negotiations as a claim for an increase in wages. 2. Official indication of inflation rate 3. One of the main indicators of a country’s economic performance. 4. Enables comparisons to be made with foreign countries relating to price competitiveness of our goods on foreign markets. 5. Provides a base for indexation of savings

Disadvantages of CPI - inaccurate indicator of changes in the cost of living? 1. Limited scope 1. The average family spends its monthly income on more than 11 different items, only some are included in the index 2. Differences in lifestyles 1. Urban v’s rural, an increase in the cost of items may affect only certain people depending on their lifestyles. 3. Consumer trends 1. CPI does not include all new items and some items may be very important in the average family household.

Disadvantages of CPI - inaccurate indicator of changes in the cost of living? 1. Overstates cost of living 1. If prices rise there will be a substitution to cheaper goods 2. Base year 1. Needs to be constantly updated 3. Quality changes 1. Doesn’t reflect quality changes for items- compensate for price increases 4. Household Budget inquiry 1. Needs to be accurate

Constant Tax Price Index A price index measures changes in the prices of goods, but excludes price changes which are caused by changes in indirect taxes. A price index measures changes in the prices of goods, but excludes price changes which are caused by changes in indirect taxes. When used with the CPI, it shows how much of the overall price change in any period is due to indirect taxes and how much is due to all other factors. When used with the CPI, it shows how much of the overall price change in any period is due to indirect taxes and how much is due to all other factors.

GNP Deflator GNP at current prices x 100 GNP at constant prices Measure of overall price changes of the economy Measure of overall price changes of the economy

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

Types of inflation 1. C reeping inflation 1. L ow steady rate of annual increase in P. levels 2. R apid inflation 1. S ignificant annual increase in P. levels 3. H yper-inflation 1. H uge increase in P. levels. Erodes PP of money

Causes of Inflation 1. Demand Pull inflation 2. Cost push inflation

1.Demand Pull Inflation Total Demand > Total Supply Total Demand > Total Supply Def: occurs when the economy cannot produce enough goods to meets the demands of its citizens Def: occurs when the economy cannot produce enough goods to meets the demands of its citizens Sellers increase profits by increasing prices Sellers increase profits by increasing prices The spending power of consumers increases faster than the production of goods and services. The spending power of consumers increases faster than the production of goods and services.  incomes,  output  incomes,  output Productivity = demand pull inflation Productivity = demand pull inflation

Demand-Pull Inflation

2. Cost push inflation Def: occurs when the selling prices of goods/services are increased to compensate the producer for an increase in the costs of production Def: occurs when the selling prices of goods/services are increased to compensate the producer for an increase in the costs of production Labour, land, capital and enterprise costs  Labour, land, capital and enterprise costs  1. Wage increases 2. Taxation 3. Import Prices

Cost push inflation Wage increase Labour costs  therefore prices so that profits maintained Taxation Direct tax/indirect tax directly/indirectly increases prices Import prices Price of raw materials  prices

Cost push inflation

Class Work!!!! In groups of 3-4 Task: ……discuss what outcomes could arise in the country if inflation increased dramatically….. Come up with 4 ideas!!!!

Problems caused by inflation 1. Savings are discouraged 1. If prices rise, money loses some of its purchasing power. 2. People tend to spend their money rather than save it. 3. Consumption  and savings  4. If savings , less funds available for lending therefore investment  5. Exports become dearer

2. Exports become dearer 1. Prices of a country’s exports  and they become less competitive on foreign markets. 2. BOP deficit and adversely affect domestic employment 3. Imports 1. Imports will become relatively cheaper than domestically produced products 2. This may replace home produced goods 3. BOP problems and loss of domestic employment.

4. The economically weaker sections of society suffer 1. People with fixed low incomes experience a fall in their real incomes 2. Prices may rise and erodes real incomes 5. Excessive wage demands 1. Trade unions may seek wage increases for its members due to increasing prices, this in turn might force inflation rate higher (cost-push) 6. Speculation is encouraged 1. Value of assets  investments in land  money moved into speculative investments

7. Borrowing is encouraged 7. Real cost of borrowing tend to be low 8. Borrowing rate maybe less than the current inflation rate 9. Real value of repayments decreases and financial burden of borrowing is less severe (demand-pull) 8. Confidence in the currency is undermined 7. Money loses its value rapidly and people tend to lose confidence in their currency

Class work!! In groups of 3-4 Discuss some ways or methods to reduce inflation 4 minutes!!!!

Curbing Inflation Reduced Aggregate Demand Demand-pull = aggregate demand exceeds aggregate supply. Demand-pull = aggregate demand exceeds aggregate supply. Aggregate demand = C+I+G+(X-M) Aggregate demand = C+I+G+(X-M) Policies that reduce C,I,G will reduce demand-pull Policies that reduce C,I,G will reduce demand-pull

a) Reducing Consumption a) Higher taxation – consumer have less disposable income to spend therefore demand falls b) Credit squeeze – restricting credit and raising interest rates will discourage borrowing and lessen the purchasing power of consumers c) Incomes Policy – restricting the size of wage increases ensures that pur.power of consumers does not increase too rapidly

b) Reducing Investment a) In practice this is not used as it can be the main source of employment creation and it forms the basis of the future wealth creating capacity. Therefore the gov tackles demand pull by reducing consumption and gov spending Reduce investment

c) R educing Gov. Spending a) T he gov. can reduce the pur.power of consumers & decrease aggregate demand by reducing gov. spending. b) G ov. can reduce expenditure by reducing: a) V olume/quality of public services b) T he no. of employees in public sector c) S ocial welfare payments d) C apital expenditure programs

This may lead to considerable opposition from sectors of the economy. This may lead to considerable opposition from sectors of the economy. This may cause unemployment, decline in (social) welfare and a decline in public investment. This may cause unemployment, decline in (social) welfare and a decline in public investment. Quick and efficient Quick and efficient Not very popular approach Not very popular approach Gov. want to be re-elected Gov. want to be re-elected May loose votes May loose votes

Controlling cost push factors: restrain the cost push influences a) Wage restraint – wage controls Principal causes of inflation Indicative planning – Gov, employers & trade unions agree on rate of pay increases for coming year. Indicative planning – Gov, employers & trade unions agree on rate of pay increases for coming year. Voluntary agreements Voluntary agreements

Prices and Incomes Policy – policies to control price increase & limiting wage increases Prices and Incomes Policy – policies to control price increase & limiting wage increases Statutory wage controls – legal ban against wage increases/increases over a certain %. Statutory wage controls – legal ban against wage increases/increases over a certain %. Gov reluctant to do this Very usual it only takes place when there are serious economic conditions

b) Controlling other costs – other factors that can cause cost push inflation Interest rates – Gov can influence the level of domestic interest rates Interest rates – Gov can influence the level of domestic interest rates Taxes – reduce direct & indirect Tax would lessen the costs to businesses Taxes – reduce direct & indirect Tax would lessen the costs to businesses

c) Productivity increases – wage increase may not cause cost push inflation. If the total output increases by the same % as the wages then unit labour costs remain unchanged

Increasing employee productivity can be difficult to achieve as employees may resist the concept of greater work. Increasing employee productivity can be difficult to achieve as employees may resist the concept of greater work. Difficult to measure productivity in the services sector Difficult to measure productivity in the services sector Increases in productivity are not realistic Increases in productivity are not realistic Increased productivity and output is of no benefit to an employer who cannot sell more. Increased productivity and output is of no benefit to an employer who cannot sell more.

Equation of Exchange- Irving Fisher Equation of Exchange- Irving Fisher This model allows us to see the effect that the quantity of money has on the economy. This model allows us to see the effect that the quantity of money has on the economy. To do this we must see how the quantity of money is related to price and incomes. To do this we must see how the quantity of money is related to price and incomes. The Quantity Theory of Money and 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 “VM” 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 “PQ” 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 constant over a certain time Therefore M=P Changes in money supply have a direct effect on the price level.

Wage/Price spiral When wage costs increase producers and sellers must increase their prices to maintain their profits When wage costs increase producers and sellers must increase their prices to maintain their profits A general increase in the level of prices leads workers to demand further wage increases so as to restore real income. A general increase in the level of prices leads workers to demand further wage increases so as to restore real income. Therefore  wages leads to  prices &in turn wages  prices  Therefore  wages leads to  prices &in turn wages  prices  Prices/incomes policy is one anti- inflammatory to control increases in wages & prices Prices/incomes policy is one anti- inflammatory to control increases in wages & prices Wage spiral

Deflation Opposite of inflation Opposite of inflation Aggregate demand < total output. This leads to falling prices Aggregate demand < total output. This leads to falling prices Deflationary policies are policies that depress aggregate demand Deflationary policies are policies that depress aggregate demand (see notes on reducing consumption, limiting wage increases and gov. spending) (see notes on reducing consumption, limiting wage increases and gov. spending)

Class work!!! In groups of 3-4 What type of inflation do you think Ireland has and what has caused this? 4mins

Inflation in Ireland In mid 1990’s our low inflation rate increased our export performance but as economic growth soared inflationary pressures built up. In mid 1990’s our low inflation rate increased our export performance but as economic growth soared inflationary pressures built up Ireland's Inflation rate was very high and the EU formally reprimanded Ireland to curtail the level of demand in the economy Ireland's Inflation rate was very high and the EU formally reprimanded Ireland to curtail the level of demand in the economy.

Irish Inflation now Irish Consumer Inflation falls sharply to 2.5% in November; Ireland is on path to deflation in 2009 for first time since 1946 By Finfacts Team Dec 11, :56:13 PM Irish Consumer Inflation falls sharply to 2.5% in November; Ireland is on path to deflation in 2009 for first time since 1946 By Finfacts Team Dec 11, :56:13 PM