$ understanding economics, richard delaney, 2008, edco cpi and inflation the consumer price index...

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¥Understanding Economics, © Richard Delaney, 2008, Edco

CPI and InflationCPI and Inflation

The Consumer Price Index and Measurement of Inflation

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Consumer Price Index and Inflation 2

A Price IndexA price index is used to show changes in

prices over a period of time.A simple price index measures the change in

the price of one product only.A composite index measures the change in

price of a number of goods together.The consumer price index is an index drawn

up by the CSO to measure the changes in the general level of prices over a period of time.

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The Harmonised Index of Consumer Prices

Abbreviated to HICP.This is the measurement of price changes

calculated by each member state of the European Union based on a harmonisation and standardisation of practices within the EU.

The purpose of the HICP is to allow for the comparison of different consumer price trends in the different member states.

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Consumer Price Index

1. The national average household shopping basket.

2. The fraction of income that the average household spends on each item.

3. The price of each item.

Every 5 years a household budget survey is conducted to establish:

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Procedure for Drawing Up the CPI

1. A base year is chosen.2. The prices of the goods in the basket are

checked every quarter.3. A simple index is made for each product

using the price in the base year as 100.4. Multiply the index for each product by its

weighting.5. Add the results to establish the CPI for each

year.

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Constructing a CPIThe following prices are established for three products for the four year period 2004–2007.It is also established that 50% of income is spent on “A” and 25% each on “ B” and “C”.

YearYear AA BB CC20042004 €1 €2 20¢20052005 €1.20 €2.50 30¢20062006 €1.25 €2.70 35¢20072007 €1.40 €2.80 40¢

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Constructing a CPI

YearYear AA BB CC20042004 €1 €2 20¢20052005 €1.2

0€2.50

30¢

20062006 €1.25

€2.70

35¢

20072007 €1.40

€2.80

40¢

AA BB CC CPICPI

2004 100 100 10050% 25% 25%50 ++ 25 ++ 25 == 100

2005 120 125 15050% 25% 25%60 ++ 31.25 ++ 37.5 == 128.75

2006 125 135 17550% 25% 25%62.5 ++ 33.75 ++ 43.75 == 140

2007 140 140 20050% 25% 25%70 ++ 35 ++ 50 == 155

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Use of / Importance of CPI Statistics

1. Used to measure the official rate of inflation.2. Used as the basis for claims for wages and

social welfare benefits increases.3. Used as one of the economic indicators.4. Used to compare our price competitiveness

on the international market. 5. Traditionally it was used as a basis for

indexation of interest rates.

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Limitations of the CPI1. It uses a limited range of products – about 8,000 products only

are included.2. It does not include new products that have come on the market

since the household survey was conducted.3. It overstates the cost of living as people switch to cheaper

substitutes when prices increase.4. The survey establishes the basket of goods of the “average”

household. There is no such thing as the average household as “ the average” is a mathematical concept.

5. It takes no account of changes in the quality of goods.6. It makes no allowance for differences in rural and urban

lifestyles.7. It makes no allowance for price increases due to increased

indirect taxes, which are used to provide extra services.

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Constant Tax Price Index (CTPI)

A CTPI is one that ignores price increases due to increases in indirect taxes.

Argument for CTPIArgument for CTPIGovernments claim that extra services are given for these taxes.

Argument against CTPArgument against CTPNot all people benefit from these services.

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Inflation

Inflation refers to the increase in the general level of prices.

There are two forms of inflation:1. demand pull inflation2. cost push inflation.

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Demand Pull Inflation

This occurs when total (or aggregate) demand in the economy exceeds total supply resulting in an increase in the general level of prices.Controls of demand pull inflation:Reducing demand in the economy by:

– increasing direct taxes.– introducing credit controls.

Increasing interest rates.Reducing government expenditure.

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Cost Push Inflation

This occurs when increases in the costs of production are passed on to the consumer in the form of increased prices.The most common causes are: Increased wages,Increased indirect taxes,Increased cost of imports.

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Control of Cost Push Inflation

1. Decrease indirect taxes – not normally an achievable or viable option.

2. Control wage increases through:– National wage agreements, – Price and income policy, – Freezing wages– Link wage increases to increases in

production only (Productivity deals).

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Summary of Problems Caused by Inflation

Causes demands for wage increases. Discourages saving. Encourages borrowings. Encourages speculation. People on fixed incomes suffer most. Exports become more expensive. Imports become relatively cheaper. Less investment in wealth creating projects.

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