Inflation

Extension reading

Measuring Inflation

All students need to understand how inflation is measured but only HL students need to know how to calculate inflation.

Key points that all students need to understand:

• The RPI/CPI is measured using a "basket of goods and services" and each category is weighted according to the % of our expenditure that we spend on each. See the video below:

• RPI/CPI

• Therefore the CPI or RPI is only a true cost of living if you are an average family. If you are very rich, very poor, single or an Old Age Pensioner then it may not give an accurate representation of your cost of living. In fact in the UK there is a cost of living index specifically for OAPs

• Changes in consumption are taken into account in that weightings are periodically changed and new goods replace old goods, but these changes are retrospective and so may be out of date.

• Quality improvements cannot be taken into account.

• Core Inflation: Inflation data can often be distorted by seasonal factors and certain goods may have very volatile prices. Therefore this volatility may distort our inflation measures, and what may appear to be the start of significant inflation in an economy is merely a short term "blip". For example unseasonal rains may create food shortages which significantly pushes up their prices. However food supplies may recover quickly and food prices may quickly return to normal. The CPI/RPI data could have misled us into thinking that the price increases were long term, when in reality they were not. Therefore as an alternative to this measure we sometimes calculate "CORE INFLATION" which is the same as the CPI but excludes food and energy prices to reduce the volatility of the index

• Producer Price Index: One limitation of the CPI index is that its' use is limited in that Governments following the RPI may act too late to control inflation. It is an indicator that inflation has already arrived. Ideally governments want "leading indicators", which are things which predict what may happen in the future. So what would be a good leading indicator of future inflation? Producer price increases are one such lead indicator, as they indicate that consumer prices may increase in the future. The transmission of producer price increases to increases in consumer price increases often occurs with a significant time lag, as distributors and retailers often first reduce their profit margins before finally increasing the price they charge to consumers. The Producer Price Index is sometimes referred to as "Factory Gate prices" as they track the price of goods as they leave the factories and before distributors add their profit margins.

• Another alternative measure of Inflation is the GDP deflator that we came across when we distinguished between money and real GDP. The GDP deflator is a comprehensive price index which measures price changes of all goods and services included in the GDP of a country. It therefore differs from the RPI in that it includes capital goods but excludes imports.

All of the above are included p225-230 in the OUP textbook.

HL Students only

A good starting point is to use the CPI as an example of a price index to explain how an index is calculated.

Both the Dorton (P236-238) and Tragakes (283-286) books have good examples of the whole process.

Answer

An alternative way to calculate an RPI is this:

Year

Price of Good X   Price of Good Y     Price of Good Z 

2010     8$                   0.6$                          $2

2011      $8.4             $0.64                        $2.05

              2012      $8.6             $0.75                        $2.25

The weightings are not given but you are told that the basket purchased includes 10X, 20Y, and 30Z. To calculate a weighted price index you must first calculate the total cost of each basket assuming the quantities given.

From there the process is the same as before. Can you attempt this- calculate the indexes for 2010-2012 and work out the annual rate of inflation for each year.

When prices are falling , consumers may decide to postpone purchases in the expectation of buying the item at a cheaper price later on. This causes a fall in demand and can create further price declines.

Deflation also causes real interest rates to rise, curbing demand. As well, falling asset prices (including housing and equities) reduce personal sector wealth and inflate the real value of debt, resulting in higher business failures and personal bankruptcies. It is clear therefore that deflation in the economy brings risks as well as opportunities. This is something that a government and the monetary authorities (i.e. the Central Bank) might be concerned to avoid.

DEFLATION AND ECONOMIC POLICY

Deflation can normally be controlled by an expansionary monetary policy with the Central Bank or the Government allowing the money supply to expand. This causes interest rates to fall and stimulates consumer spending and investment demand. Occasionally though, when prices are falling, lenders may call in loans or refuse to lend out to potential borrowers. This is known as a credit crunch.

Cutting interest rates may not be sufficient during a credit crunch. In this case, expansionary fiscal policy (lower direct and indirect taxes and higher government spending) is often prescribed to cure deflation.

One reason deflation is difficult to cure is that nominal interest rates cannot fall below zero, while prices of goods and services can fall for a long time. In this event, monetary policy is unable to prevent higher real interest rates and the economy spirals downwards towards a slump caused by falling prices, contracting output, falling investment, plant closures and increasing levels of job losses in those industries affected.

"Deflation" is occurring in the markets for some goods in the UK economy. The annual rate of inflation for products such as textiles and audio-visual equipment has been negative for some time leading to cheaper prices for consumers and an increase in their real purchasing power.

What is wrong with deflation (Video)