Price Level

Inflation

steady + persistent increase in general price level

a given qty of money will purchase less goods

Simple Price Index

* Unweighted index
* Show % change in price of a good over period of time
* does not take into account fraction of income spent on each good

Simple Price Index method

1. Choose base year (always has index of 100)
2. Find price of good each year
3. Calculate index number for each year
4. (this year's price ÷ price in base year) x 100

Composite Price Index

* Does not give equal importance to each good
* goods given weight which reflects fraction of income spent on it
* Most common index in Ireland
* Measures change in avg prices paid for goods/services by all private households

Composite Price Index method

1. Choose base year
2. Decide goods to include
3. Find price of goods each year
4. Calculate simple price index for each good
5. Find % of income spent on each good (weight) (est. by Household Budget Survey (CSO))
6. Multiply each simple index by its weight and add together

Uses of CPI

* Measure rate of inflation
* Measure of economy
* Wage negotiations
* Adjustment of tax bands
* Maintenance of social welfare payments
* Internat. competitiveness

Limitations of CPI

* Based on averages
* Household Budget Survey only every 5 years
* Does not measure changes in quality of goods
* Ignores switches to cheaper brands
* Price index, not cost of living index

4 causes of inflation

Demand-pull

Cost-push

Gov-induced

Printing money

Demand-pull inflation

occures when aggregate demand for goods/services > aggregate supply of goods/services

In Small Open Economy, excess demand usually filled by imports

Housing/non-imported services = inflation

Cost-push inflation

rise in cost of production (eg labour) is passed on to consumers in form of higher selling prices

Wage Drift – occurs when high demand for labour = firms paying above negotiated rates (e.g. builder during boom)

Gov-induced inflation

Increase in indirect taxes

Increase in gov spending (Demand-pull)

Increased availability of credit/decreased interest rates (Demand-pull)

Econ Effects of Inflation

* If increase in Selling price > increase in costs = production encouraged
* Consumption encouraged (Inflation psychology)
* Lower standard of living (fixed incomes lose most)
* Borrowers gain/lenders lose

Hyperinflation

* rapid inflation
* money loses value to point alt. methods of exchange used
* causes lack of confidence in currency + great instability
* e.g. Weimar republic (early 20s)

Econ Effects of Deflation

* consumers postpone spending in hope price will fall further
* Decrease in aggregate demand -> stagnation in economy -> increase in unemployment -> loss of consumer confidence

MONETARY POLICY

use of interest rates/ money supply/ credit availability to achieve objectives

Impacts of High interest rates on inflation

* discourages borrowing
* fall in demand
* incentive to save
* reduce inflation

Impact of Low interest rates on inflation

* encourages borrowing
* rise in demand
* incentive to spend rather than save
* increase inflation

Quantitative easing

when central bank buys financial assets from commercial banks with money they have newly printed

ECB inflation goal

Benefits of Price Stability

* Consumer confidence increases = spending + investment
* Spending increases gov revenue
* Decreased social unrest
* fixed income workers don’t have a decreased standard of living
* Saving may increase (depends on inflation rate/ interest rate relationship)

Effects if supply of money grows faster then production of goods/services

* Inflation (more money chasing goods)
* Increase in imports (to fill gap between supply + demand)
* Fall in exchange rate (increased money supply + increased demand for imports)
* Interest rates fall (more money available = “price” of money falls)

Effects if supply of money grows slower then production of goods/ services

* deflation
* Decline in econ. growth -> increased unemployment -> decreased aggregate demand
* Decreased demand for imports
* Rise in exchange rates (supply of money < demand)
* Interest rates rise (insufficient supply =“price” of money rises)