3.3.4 Low and stable rate of inflation Notes

1. Price stability is a fundamental macroeconomic goal for any economy.
2. As we will discover in this section, when prices remain relatively stable:
   1. Consumers can make confident spending decisions.
   2. Businesses can plan investments effectively.
   3. The overall economy can function more efficiently.

Measuring inflation using the consumer price index (CPI)

1. The CPI is used by economies worldwide to track inflation (or deflation).
2. It does so based on the percentage change in the basket's value over time.

Calculating inflation

With the CPI provided, the inflation rate can be calculated by using this formula:

$$\text{Inflation Rate}=\frac{(100\text{Weighted Price Index}−100​)} \times 100$$

Table 1 above shows the CPI data for an imaginary economy, Econland. The inflation rate for each year can be calculated by using the formula above.

From Year 1 to Year 2:

• CPI in Year 2 = 105
• CPI in Year 1 = 100
• Inflation Rate: $\left( \frac{105 - 100}{100} \right) \times 100 = 5.00\%$

From Year 2 to Year 3:

• CPI in Year 3 = 110
• CPI in Year 2 = 105
• Inflation Rate: $\left( \frac{110 - 105}{105} \right) \times 100 = 4.76\%$

From Year 3 to Year 4:

• CPI in Year 4 = 120
• CPI in Year 3 = 110
• Inflation Rate: $\left( \frac{120 - 110}{110} \right) \times 100 = 9.09\%$

From Year 4 to Year 5:

• CPI in Year 5 = 125
• CPI in Year 4 = 120
• Inflation Rate: $\left( \frac{125 - 120}{120} \right) \times 100 = 4.17\%$

The limitations of the CPI in measuring inflation

Several limitations affect CPI's accuracy as a measure of inflation. Some of these limitations include:

1. Substitution bias:
   1. When prices rise, consumers switch to cheaper alternatives.
   2. CPI uses fixed weights and doesn't capture these changes.
   3. Results in overestimating actual cost increases.
2. Quality changes:
   1. New quality improvements aren't fully reflected.
   2. Therefore, price increases due to quality improvements are counted as inflation.
3. New products:
   1. The CPI basket takes time to incorporate new products and services.
   2. This delay means important consumption changes aren't quickly reflected.
   3. Thus, the index can become outdated in rapidly evolving markets.
4. Regional differences:
   1. CPI uses national average prices that don't reflect local/regional variations.
   2. In reality, living costs can vary significantly between urban and rural areas.
   3. A single national figure may not represent any actual location's experience.

Causes of inflation

There are two types of inflation studied in the IB curriculum: demand-pull inflation and cost-push inflation.

Demand-pull inflation

Demand-pull inflation is represented in the AD-AS model by a rightward shift in the aggregate demand (AD) curve (Figure 1).

1. At initial equilibrium ($E_1$) the market is in balance. The price level is at $PL_1$, and the real output is at $Y_1$.
2. As aggregate demand increases (due to an increase in one of tis components), the AD curve shifts rightward ($AD_1$ → $AD_2$).
3. As a result, price level rises ($PL_1$ → $PL_2$), and output increases ($Y_1$ → $Y_2$). This shows both inflation and economic growth.
4. As seen, higher aggregate demand has pulled prices upwards.
5. Since output cannot expand enough to meet all new demand, demand-pull inflationary pressures rise.

Cost-push inflation

Cost-push inflation is shown in the AD-AS model by a leftward shift of the AS curve (Figure 2).