Economic assignment of inflation (usama shehzad sr.ii s) (1)
Qs.1 What are the uses of consumer price index ?
ANS. As an economic indicator. As the most widely used measure of inflation, the CPI is
an indicator of the effectiveness of government fiscal and monetary policy. Especially
for inflation targetingmonetary policy by the Federal Reserve; however, the Federal
Reserve System has recently begun favoring the Personal consumption expenditures
price index (PCE) over the CPI as a measure of inflation. Business executives, labor
leaders, and other private citizens also use the CPI as a guide in making economic
As a deflator of other economic series. The CPI and its components are used to adjust
other economic series for price change and to translate these series into inflation-free
As a means for indexation (i.e. adjusting income payments). Over 2 million workers are
covered by collective bargaining agreements which tie wages to the CPI. In the United
States, the index affects the income of almost 80 million people as a result of statutory
action: 47.8 million Social Security beneficiaries, about 4.1 million military and
Federal Civil Service retirees and survivors, and about 22.4 million food stamp
recipients. Changes in the CPI also affect the cost of lunches for the 26.7 million
children who eat lunch at school. Some private firms and individuals use the CPI to keep
rents, royalties, alimony payments and child support payments in line with changing
prices. Since 1985, the CPI has been used to adjust the Federal income tax structure to
prevent inflation-induced increases in taxes.
Qs.2 What are the limitation of consumer price index ?
ANS. The CPI is subject to both limitations in application and limitations in measurement.
Limitations of application
The CPI may not be applicable to all population groups. For example, the CPI-U is
designed to measure inflation for the U.S. urban population and thus may not accurately
reflect the experience of people living in rural areas. Also, the CPI does not produce
official estimates for the rate of inflation experienced by subgroups of the population,
such as the elderly or the poor. (BLS does produce and release an experimental index for
the elderly population; however, because of the significant limitations of this
experimental index, it should be interpreted with caution.)
The CPI cannot be used to measure differences in price levels or living costs between one
place and another; it measures only time-to-time changes in each place. A higher index
for one area does not necessarily mean that prices are higher there than in another area
with a lower index. It merely means that prices have risen faster in the area with the
higher index since the two areas' common reference period.The CPI cannot be used as a
measure of total change in living costs because changes in these costs are affected by
(such as social and environmental changes and changes in income taxes) that are beyond
the definitional scope of the index and so are excluded.
Limitations in measurement
Limitations in measurement can be grouped into two basic types, sampling errors and
Sampling errors. Because the CPI measures price changes based on a sample of items,
the published indexes differ somewhat from what the results would be if actual records
of all retail purchases by everyone in the index population could be used to compile the
index. These estimating or sampling errors are limitations on the accuracy of the index,
not mistakes in calculating the index. The CPI program has developed measurements of
sampling error, which are updated and published annually on the CPI home page. The CPI
sample design allocates the sample in a way that maximizes the accuracy of the index,
given the funds available.
Non sampling errors. These errors occur from a variety of sources. Unlike sampling
errors, they can cause persistent bias in measurements of the index. Nonsampling errors
are caused by problems of price data collection, logistical lags in conducting surveys,
difficulties in defining basic concepts and their operational implementation, and
difficulties in handling the problems of quality change. Nonsampling errors can be far
more hazardous to the accuracy of a price index than sampling errors. Hence, BLS
expends much effort to minimize these errors. Highly trained personnel ensure the
comparability of quality of items from period to period ; collection procedures are
extensively documented, and recurring audits are conducted. The CPI program has an
ongoing research and evaluation program in order to identify and implement
improvements in the index.
Qs.3 How many types of inflation are there ?
Ans. Demand Pull inflation :
This type of inflation results due to the increase in Aggregate demand in the economy.
The movement of aggregate demand from AD1 to AD2 results in an increased average
price level in the economy i.e. P1 to P2.
Cost Push Inflation :
Increase in cost of production will result in cost push inflation. As the cost of production
increases, the firms will reduce supply. The aggregate supply will shift to the left, from
SRAS1 to SRAS2. This will result in an increase in the average price level in the economy.
Real output will fall.
Cost Push inflation is mainly caused due to the following factors:
· increase in wages (wage push inflation)
· increase in cost of raw materials
· increased cost of imported components (import-push inflation).
Inflationary Spiral :
It is self-sustaining upward trend in general price levels due to interaction of demand pull
and cost push inflation. It is also known as Wage price spiral. High cost of living prompts
demands for higher wages which push production costs up forcing firms to increases
prices, which in turn trigger calls for fresh wage increases ... and so on.
Monetarists view of inflation :
As per monetarists (new classical economists) inflation is caused due to the excessive
supply of money in the economy. According to monetarists an increase in money supply
results in higher aggregate demand from AD1 to AD2. Monetarists assume the economy
to operate as full employment level of output, thus, any increase in AD is purely
Qs.4 How to control inflantion ?
Ans. Government Policies to control Inflation :
Government uses a number of policies to deal with the different types of inflation. These
Demand Side policies-to control demand pull
Deflationary fiscal policy: This involves an increase in taxes and lowering of government
spending. Increasing taxes will result in lower disposable income for household and thus
less consumption. Moreover, increased taxes will result in lower profits for firms and
thus less investment by firms. All these factors will lower the AD in the economy.
Deflationary monetary policy: It involves rising of interest rates and reducing money
supply. Higher interest rates mean higher loan and mortgage repayments. This will deter
households and firms to borrow, leading to fall in consumption and investment
Supply side policies-to control cost push inflation
It includes all those policies which aim at improving the efficient supply of goods and
services. These might include:
Imparting training and improving the education level of the workforce resulting in higher
Increase competition in all industries by removing entry barriers, thus leading to more
Exchange rate policies to control imported inflation
This involves increasing the value of currency to reduce imported inflation. Increase
currency rate will also lead to fall in demand for exports (component of AD).
Qs.5 What are the effects of inflation ?
Ans. Effects of Inflation
Increase in production and investment: Inflation motivates producers increase
production as their goods or services will earn more profits (law of supply).
Greater inequality of income: Poor people more adversely affected by inflation. Inflation
widens the gap between rich and poor.
Balance of trade: Inflation will cause the prices of the goods and services to go up. It will
make the country’s exports less competitive in the international market and have a
negative effect on the balance of trade.
Exchange rate: High rate of inflation will affect the external value of money or the
exchange rate of the country. Other countries will find the currency more expensive and
hence there will be less demand for it and the value of currency will fall.
Who gains, who loses
Businessmen gains as the prices
of their products go up and so
does their profits.
Farmer’s cost of production will
not go up drastically in the short
run and thus will ain.
Shareholders will get better
returns as businesses will be
making more profits.
Governments that are in debt will
also find their burden reduced.
Debtors will gain as the real value
of money has gone down since
the time they took the loan.
Creditors lose as the principle
sum received is less in terms of
Wage earners will find their real
wages going down and thus lose.
Pensioners usually have a fixed
income and will lose.
Students, unemployed people
Bondholders, those who have
purchases bonds from
government and companies will
Qs.6 Is inflation benificial ?
ANS. Deflation (a fall in prices – negative inflation) is very harmful. For example, the
Japanese economy has suffered lower growth because of deflation. When prices are
falling people are reluctant to spend money because they are concerned that prices will
be cheaper in the future, therefore, they keep delaying purchases.
Moderate inflation enables adjustment of prices and wages. It is argued a moderate rate
of inflation makes it easier to adjust relative wages and prices. For example, it may be
difficult to cut nominal wages (workers resent wage cut). But, if average prices are rising,
it is easier to increase good workers wages more than unproductive workers.
Inflation can boost growth. At times of very low inflation the economy may be stuck in a
recession. Arguably targeting a higher rate of inflation can enable a boost to growth. This
view is controversial. Not all economists would support targeting a higher inflation rate.
However, some would target higher inflation, if the economy was stuck in a prolonged
Inflation is considered to be a problem when the inflation rate rises above 2%. The higher
the inflation, the more serious the problem it is.
In a modern economy, the Government are most concerned about the destabilising impact
Inflationary growth tends to be unsustainable leading to a damaging period of boom and
bust economic cycles.
Inflation tends to discourage investment and long term economic growth. This is because of
the uncertainty and confusion that is more likely to occur during periods of high inflation.
Inflation can make an economy uncompetitive. For example, higher rate of inflation in Italy
can make Italian exports uncompetitive. This is particularly important for countries in the
Euro-zone because they can’t devalue to restore competitiveness.
Reduce value of savings. Inflation leads to a fall in the value of money. This makes savers
worse off and can lead to a redistribution of income in society. Often it is pensioners who
lose out most from inflation. This is particularly a problem if inflation is high and interest
Menu costs – costs of changing prices lists. Not so significant with modern technology.
Qs.7 Consequences of inflation ?
ANS. Consequences of inflation :
High inflation rate may result in the following adverse effects on the economy:
Greater uncertainty: There may be greater uncertainty for both firms and households.
Firms will postpone their investment due to uncertainty in the market. This will result in
negative implications on the economic growth in the economy.
Redistributive effects: High rate of inflation will affect people who have constant
incomes, such as retired people, students, and dependents. Moreover, rise in prices of
essential commodities (food & clothing) will affect the poor segment of the society as
they spend a major part of their income on these good. This will lead to increased
inequality in the economy.
Less saving: High rate of inflation will have an adverse effect on the savings in the
economy. As people spend more to sustain their present standard of living, less is being
saved. This will result in less loanable funds being available to firms for investment.
Damage to export competitiveness: High rate of inflation will hit hard the export
industry in the economy. The cost of production will rise and the exports will become less
competitive in the international market. Thus, inflation has an adverse effect on the
balance of payments.
Social unrest: High rate of inflation leads to social unrest in the economy. There is
increase dissatisfaction in among the workers as they demand higher wages to sustain
their present living standard. Moreover, high rate of inflation leads to a general feeling of
discomfort for the household as their purchasing power is consistently falling.
Interest rates: The Central Bank might use monetary tools to control high inflation rate
by increasing interest rates. This will increase the cost of borrowing and will have a
negative effect on both consumption and investment.
Shoe leather cost refers to the cost of time and effort (more specifically the opportunity
cost of time and energy) that people spend trying to counter-act the effects of inflation,
such as holding less cash and having to make additional trips to the bank.
Menu cost is the cost to a firm resulting from changing its prices