macro ch 6 Consumer Price Index (CPI), Inflation and Fiscal Policies

The Consumer Price Index (CPI)

measures the change in retail prices of a representative basket of goods and services

measured monthly

change in the value of the CPI

used to calculate the inflation rate (%)

𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 equation

(𝐶𝑃𝐼 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑜𝑛𝑡ℎ − 𝐶𝑃𝐼 𝑜𝑓 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑚𝑜𝑛𝑡ℎ)
divided by 𝐶𝑃𝐼 𝑜𝑓 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑚𝑜𝑛𝑡ℎ

𝑥 100%

𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 equation

𝐶𝑃𝐼 𝑜𝑓 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑜𝑛𝑡ℎ − 𝐶𝑃𝐼 𝑜𝑓 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 (𝑖𝑛 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑚𝑜𝑛𝑡ℎ)
𝐶𝑃𝐼 𝑜𝑓 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 (𝑖𝑛 𝑡ℎ𝑒 𝑠𝑎𝑚𝑒 𝑚𝑜𝑛𝑡ℎ) 𝑥 100%

Inflation

generalized and sustained growth in the prices of goods and services of an economy

The requirements for a price increase to be considered inflation are:

1.Generalized: prices of the majority of goods/services go up
2. Sustained (continuous) prices higher over time

The price of coffee goes up
for several months in a row

Not generalized → Not inflation

Inflation: Differences between GDP deflator and CPI

GDP deflator: measures prices of all g&s produced domestically in the economy, weights change as composition of GDP changes

CPI: only measures those purchased by consumers. Based on a pre-determined basket w chosen/fixed weights

Inflation: Other problems with CPI

-does not take into account substitutes between goods
-doesn’t deal well w introduction of new goods/services in the market.
-difficulties taking into account changes in quality

Low, stable and predictable inflation is beneficial as:

• Moderate inc. in price levels keeps businesses profitable (more investment/higher salaries/employment, etc).
• Prevents consumers from waiting for lower prices before purchasing
→ Mild or moderate inflation encourages economic activity.

high inflation is detrimental to the economy as it causes:

-Loss of purchasing power: if prices rise more than wages

-Rise in basic necessities’ prices,affects the
poorest
-Uncertainty: prices rise unpredictably, uncertainty settles (lower investments/business closures/layoffs)
-Rising prices: harder to save/lend money (lenders get money back its worth less)

deflation (or negative inflation)

generalized & sustained dec. in price
level of g&s of economy,

households/businesses wait 2 purchase (expecting prices 2 drop further) → Companies sell less/lay off their
workers (lowering GDP and increasing unemployment).

Demand-driven inflation. Occurs when there is an excess demand for goods due to the fact that
demand is growing faster than supply (growing demand for goods or services meets insufficient
supply) → which drives prices higher. The higher the flexibility of supply, the lesser the chances of
suffering high inflation due to demand increases.

Cost-driven inflation

Costs of companies (wages, raw materials, inputs, energy,etc) inc. → More expensive 2 produce →companies inc. prices → workers ask 4 wage increases

Higher costs for companies →higher prices

Money supply-driven inflation

More money in circulation=higher the inflationary
pressure→ppl tend 2 consume more

Aggregate Demand

Measurement of total amount of demand for all finished (final)goods/services produced in an economy

total amount $exchanged 4 those goods and services @ specific price level & pt. in time.

Sum of Consumption, Investment, Public Expenditures and Net Exports

Aggregate supply

total $ amount of goods/services firms r willing 2 produce/supply @ given price in a country

Aggregate Demand (AD) of a country is equal to

its GDP at market prices

Aggregate demand equation

GDPmp = Aggregate Demand (AD) so…
AD= Consumption + Investment + Public expenditure + Exports - Imports

The aggregate demand curve

quantity of goods/services demanded by all
economic agents for each price level.

downward-sloping: higher prices=lower demand

The aggregate supply curve

quantity of goods/services supplied by firms for each price level
upward-sloping: higher the prices=higher supply

FISCAL POLICY

set of measures taken by State on public spending, taxes and transfers 2 influence economy's spending (Aggregate Demand) and achieve different macroeconomic objectives

fiscal policy macroeconomic objectives:

-sustained GDP growth

-employment

-price stability,
-budgetary balance & external balance

Direct and indirect government fiscal policy

Directly G (public expenditures)

Indirectly through taxing/transfers, household consumption (C), and companies’ investments (I).

Taxes

payments by families/firms 2 the State results in lower
disposable income.

Represent revenues 4 gov.

Transfers

State aid 2 families/firms 2 have a higher disposable
income (unemployment benefits, pensions and other benefits).

Another source of expenditures for the government (apart from public expenditures)

Different taxes

-Tax on personal income

-Corporate tax

-Value added tax (VAT)

-Excise duties (tobacco, alcohol, oil, plastics etc).

Expansionary Fiscal Policy

2 stimulate an increase in spending in the economy (shift right of aggregate demand curve) through…

inc. in gov. spending

inc. in transfers

decrease in taxes

Pos/Neg effects expansionary fiscal policy

Positive effects: Higher GDP & Lower Unemployment
Negative effects: Higher inflation& Greater Fiscal Deficit

COVID crisis stimulus packages in the form of:

-Transfers 2 households 2 improve consumer spending reduce inequality
-Transfers to firms (loans) & short-time programs (2 not fire workers during crisis)
-Resources for health care: increased the gap between
expenditures and revenues (fiscal deficit)

-Fiscal Policy: Expansionary Fiscal Policies

Contractionary Fiscal Policy

2 control inflation and/or improve the fiscal balance

by decreasing public expenditures, increasing taxes or reducing transfers
shift left of the agg. demand curve

Contractionary Fiscal Policy positive/neg effects

Positive effects: Inflation can be reduced, Healthier budget balance
Negative effects: Lower GDP, Higher unemployment