Presentation on theme: "Revision: The price level"— Presentation transcript:
1 Revision: The price level (The consumer price index & inflation)InflationDefinitionCauses of inflationCost-push inflationDemand-pull inflationGovernment caused (induced) inflationEffects of inflationHow to reduce inflationDeflationHow is it causedWhat it results inMeasuring the changes in pricesSimple Price IndexComposition Price IndexConsumer Price IndexHow accurate it is?Uses of the CPI
2 Inflation……Is defined as the steady and persistent increase in the general level of pricesThis results in the value of money of money falling and the cost of living increasingTherefore one cannot buy the same quantity of goods and services they could have in the previous year
3 Simple price indexShows the percentage change in the price of the good over a specific time periodIt is an unweighted price index as it does not take into account the fraction of income spent on the good.3 steps involvedNew Price XBase Year Price
4 Composite Price IndexEach good is assigned a “weight” which reflects the percentage of income which is spent on it.It is a weighted price index and shows the effect to the overall cost of living due to changes in the price of goods.6 steps involved
5 Workbook, page 107, question 10 For a composite (weighted) price index covering the three types of expenditure given in the following table, calculate the index for the current year. The base year value is Show your workings.Category% of income spent on the itemPrice of item in base year (Euro)Price of item in current year (Euro)Food358.5012.75Clothing and footwear1537.5045.00Other items5020.0035.00100
6 Solution…… Category Prices of item(s) Base Year Calculation of Simple Price Index X WeightEuroFood8.5012.75 X = X 35% =Clothing & footwear37.5045 X = X 15% =Other items20.0035 X = X 50% =20Price Index for the Current Year
7 The Consumer Price Index Today………….The Consumer Price IndexHow accurate is itHow it is constructedThe economic uses of the CPI
8 The Consumer Price Index The CPIThe Consumer Price IndexIt measures the change in the average level of prices paid by all private household on consumer goods/services.It began in January 1997, it is compiled on a monthly basis covering over a thousand items.The Household budget survey is carried out every five to seven years to find out the fraction of income spent on each items.This survey is carried out to get accurate details of consumers spending patterns.
9 What are its limitations??? How accurate is the CPI???What are its limitations???It is based on average spending patternsWeights used apply in the base year onlyChanges in quality of goods is not measuredNew products on the Market are not includedSwitching to cheaper brands is not measured
10 2007, Higher, Section B, Question 7 A (ii) Explain how a Consumer Price Index is conducted?1. It is based on the “National Average Family Shopping Basket”Those items which the average Irish family buys frequently and in large quantities are included.2. Expenditure patterns are divided into various categoriesThe CPI contains various categories of expenditure; food, alcohol, clothing & footwear, housing, transport etc.
11 3. Calculation of “Weight” The weight is the fraction of income which is spent on each category of expenditure, obtained through the Household Budget Survey, only takes place every 5 to 7 years.4. Prices in Base Year ChosenThe average cost of the items is equal to 100 e.g. – milk 40%, bread 35% and apples 25%. This makes it easier to compare in future years.5. Prices in Current Year DeterminedThe current prices of each item are collected from a panel of retail and service outlets in various locations throughout the country.
12 Economic uses of a CPIMeasure the rate of inflationMeasure International CompetitionIndexation of savings/investmentsMaintaining the real value of social welfare paymentsWage negotiations
13 Inflation………. Causes of inflation Effects of inflation Cost-push inflationDemand-pull inflationGovernment caused (induced) inflationEffects of inflationHow to reduce inflationDeflationHow is it causedWhat it results in
14 Causes of inflation………. Cost-pushDemand-pullGovernment induced
15 Cost push inflation…….Any increase in the general level of prices due to an increase in the costs of production/costs of inputs faced by the employer.This can be due to………Increased wage demands due to the minimum wage or social partnership agreementsIncreased prices for raw materials, e.g. – oilIncreased costs of production e.g. – utility charges, rent costs, insurance costs.
16 Demand pull inflation………. Is when the economy cannot produce enough goods and services to meet the demand of citizens. Too much money is said to be “chasing” too few good. Therefore demand is greater than supply and producers see an opportunity to increase prices.This can be due to…………….Goods cannot be manufactured/imported quick enough to meet new demandUnexpected increase in consumer confidenceFirms with monopoly power take advantage of their position by raising prices
17 Government induced inflation………. A rise in prices as a result of some action by the government.This can be due to………An increase in indirect taxes, e.g. – VATA decrease in direct taxes, e.g. – PAYE can cause demand pull inflation as [people will have more money to spendAn increase in lending by the banks
18 Effects of inflation………. Lower Standard of livingPurchasing power of money fallsIncreased wage demandsLoss of competitivenessLoss of employmentBorrowing encouragedIncreased disparity between different sectorsA rise in government spendingProduction encouragedUncertainty
19 Reducing inflation………… Use measures that take money out of the economy and reduce demand.Fiscal policyIndirect taxes - VATDirect taxes – PAYESaving scheme - SSIALower government spendingNational wage agreementsIncreased competition
20 Today……………….DeflationHow it is causedWhat it results in
21 Deflation Is negative inflation – Prices are going down rather than up.
22 Deflation can be caused by………. Over supply relative to demand, e.g. – more hotel rooms than there are people to stay in themA sudden drop in demand or investment or government spending or all three, e.g. – in a recessionPersistent unfavorable balance of payments – more money leaving the country on imports than coming in on exports
23 Results of deflation………. An increase in the purchasing power of money - Employers use this to justify wage cuts and the government uses it to justify cuts in social welfare.The government can save money on capital projects – cost of construction and raw materials falls.Increased national competitiveness – provided that Irish prices fall by more than competing countries’ prices do.