CPI inflation --econs

inflation defintion

Sustained increase in the general price level or average price level of goods and services in a country over a period of time , usually a year (it lowers PP)

deflation definition

sustained decrease in the general price level or average price level of goods and services in a country over a period , usually a year (higher PP)

disinflation

decrease in the rate of inflation

• still have inflation , just at a slower rate

• Prices are still rising, but they are rising more slowly than before.

change in rate of inflation differs from inflation because/rate of inflation definition

rate of inflation —> change in how fast the price level is rising

causes of inflation

1. demand pull inflation

2. cost-push inflation

demand pull inflation

• caused by increase in AD , in turn brought about by changes in any of the determinants of AD

• the increase in APL due to an increase in AD is called demand-pull inflation (the inflationary gap)

• when an economy Is already operating at full employment equilibrium level, any further increase in AD will only result in an increase in average price level and no increase in level of real GDP

Cost-push inflation

• caused by an increase in costs of production (cause SRAS to fall) or supply side shocks

• represented by a decrease in SRAS, inflation + fall in real GDP + unemployment

• increase in APL due to fall in SRAS is known as cost-push inflation

• stagflation present — both inflation and unemployment present

• deflationary gap diagram

inflation due to excess monetary growth

• excessive increase in money supply by government cause inflation

• more money spent , increase C in AD , in the LR will have inflationary gap

real income

purchasing power, refers to what your money can buy, adjusted to inflation

• decreases as prices rise

• increases as prices fall

nominal income

does not consider inflation , the amount of money you receive in dollar term??

Purchasing power

how many goods and services your money can buy

(formula*)percentage change in real income =

%change in nominal income (not adjusted to inflation)- %change in price level

• this is rate of inflation

Costs of inflation

1. Loss of purchasing power

2. Effect on savings

3. Effect on interest rate

4. Effect on international competitiveness

5. uncertainty

6. labour unrest

loss of purchasing power

If wages do not increase at the same rate as inflation , real income falls , reducing the purchasing power of households. For example , during the UK public sector wage squeeze between 2021 to 2023 , healthcare workers and teachers faced nominal wage increases capped around 3-5%. However, inflation peaked at 11.1% in October 2022 , causing the costs of groceries and rent to increase significantly. Because prices increased at a faster rate than their wages , these households experienced a significant drop in their real income , reducing their overall purchasing power and standard of living

effects on international competitiveness

If a country’s inflation rate is higher than that of its trading partners, its exports become more expensive while imports become cheaper. For example , in October 2022, UK’s inflation exceeded 11%. Many British manufacturers faced rapid rising energy and labour costs, increasing cost of production. As UK goods become more expensive than products from countries with lower inflation rates , it is harder for exporters to compete internationally.  UK exports became relatively more expensive in international markets, reducing foreign demand and weakening the UK's price competitiveness against producers in other countries. Thus, proving that sustained inflation can weaken export competitiveness unless improvements or currency depreciation offsets the rising production costs.

effects on interest rate

Central banks often increase interest rates to reduce AD and control inflation. When interest rates increase , the cost of borrowing increases. Now , businesses are less willing and able to borrow from the bank , reducing investment and causing AD to fall. For example , following the post pandemic inflation , the Federal Reserve raised their interest rates from near 0% in early 2020 to a peak of over 5% in July 2023.  Since businesses faced higher borrowing costs, investment slowed down. Hence, although raising interest rates can reduce inflation , it comes at a cost of slower economic growth

uncertainty

High and unpredictable inflation creates uncertainty for firms .For example, between 2007 to 2008, Zimbabwe experienced hyperinflation. Many firms closed and foreign investors also avoided Zimbabwe due to extreme economic uncertainty. Hence, when inflation becomes uncertain , it discourages investment and damages a country’s long term growth.

Policies to solve inflation — demand pull

1. contractionary fiscal policy

2. monetary policy

Policies to solve inflation — cost push

1. demand side policies (may reduce APL but results in lower real national income + higher unemployment)

2. supply side policies

hyperinflation

refers to extraordinary high and uncontrollable rates pf inflation that causes serious macroeconomic problems

index numbers

• used when making comparisons over time

• an index starts in a given year (base year) and is given an index number of 100

• negative change —→ price fall to below 100

• Positive change —> price rise to above 100

price index formula

price year_n / price base year x 100

• no units

consumer price index

a measure of the cost of living or the cost of goods and services purchased by the typical household in an economy

• “basket” of consumer good , fixed in quality and quantity

• reflects price movements and not actual price levels

• weighted index — items that form a higher proportion of household expenditure have larger “weights” assigned to them

inflation rate

percentage change in the consumer price index over a period of time

• CPI₂-CPI₁ / CP1₁ X 100%

positive inflation figure vs negative inflation figure

Positive inflation figure implies that average price levels have increased as compared to the previous years

Limitations of using CPI as a measure of inflation

1. CPI does not account for disproportionate impact

2. CPI may not reflect the true cost of living for all individual families

3. CPI may overstate inflation if it does not accurately adjust for the better quality of goods and services

4. CPI basked updated infrequently , might not represent current spending patters of consumers at any given moment

CPI does not account for disproportionate impact

• When the price of a good , for example a necessity, increases, the impact on the standard of living of the low income will be greater than on the high incomes. For example , following the Russia-Ukraine War , Russia reduced natural gas exports to Europe. This caused countries like Italy and Germany to experience high energy bills. Although each country’s CPI reported the average inflation rate , low income households were disproportionately affected because they devoted a larger share of their income to electricity and heating. Thus, CPI does not account for the disproportionate impact.

CPI may not reflect the true cost of living for all individual families 

• Different households buy different baskets of goods and in varying proportions. Since CPI uses an average basket of goods , it may not reflect the true cost of living for all individuals or families. For example, during the post-pandemic inflation surge in the US, medical care and housing costs increased significantly across the US. Older Americans generally spend a larger proportion of their income on healthcare than younger households. Consequently , many elderly households experienced a higher increase in their cost of living than indicated by the overall US CPI.

CPI may overstate inflation if it does not accurately adjust for the better quality of goods and services

Price increases are sometimes a result of advancements in technology or better quality products rather than inflation . For example , smartphones. Between 2010 and 2025 , smartphones have gradually become more and more expensive. Much of the price increase reflects the improvement in quality and advancement in technology rather than inflation alone. However, since quality improvements are difficult to measure accurately , the CPI may overstate inflation if it does not accurately adjust for the better quality of goods and services

CPI basket updated infrequently , might not represent current spending patterns of consumers at any given moment 

• Consumer behaviour can change relatively quickly , causing the goods in the CPI basket to be an inaccurate reflection of the types of goods currently consumed if it is not updated regularly.  For example , during the Covid-19 Pandemic , spending on public transport fell sharply while spending on groceries increased. However, many CPI baskets still reflected pre-pandemic expenditure patterns , causing the CPI basket to not represent the current spending patterns of consumers at that given moment.