3.3.2 LOW/STABLE INFLATION 3.3.4

With reference to the above table complete these sentences:-

• "The same basket of goods in 2008 cost _% LESS/MORE than in the base year"

• "The same basket of goods in 2010 cost _% LESS/MORE than in the base year"

• "The same basket of goods in 2011 cost _% LESS/MORE than in the base year"

• In order to compare basket prices, the WEIGHTINGS NEED TO BE FIXED, however, IT IS NATURAL FOR CONSUMERS TO CHANGE THE QUANTITIES THEY BUY when the prices of individual items rise and fall. They will BUY LESS of those ITEMS WITH HIGHER PRICE CHANGES, thus reducing their weighting, and BUY MORE CLOSE SUBSTITUTES with relatively LOWER PRICE CHANGES increasing their weighting. However, since the weightings stay fixed for at least 24 months, the CPI will OVERSTATE the RISE in the COST OF LIVING.

• We have already seen that due to numerous variables, consumer spending can differ from HOUSEHOLD to HOUSEHOLD and the basket's fixed content and weightings do not always accurately represent household expenditure. Given that baskets content and weighting differ from COUNTRY to COUNTRY, international comparisons are even more inaccurate.

-See the importance of onions to Indians.

• Do you think the basket of the 1950s is the same basket as the 2020s? Of course not, the BASKET'S CONTENT & WEIGHTINGS ARE REVISED AT LEAST ONCE PER DECADE, as such comparisons of more than this length are less accurate.

--EXPLAIN WHY THE CPI MAY OVERSTATE THE INCREASE IN THE COST OF LIVING OF A TYPICAL HOUSEHOLD (10)--

• There are certain goods, notably FOOD and ENERGY products (such as oil) that have HIGHLY VOLATILE PRICES (meaning they fluctuate widely over short periods of time). Reasons for price volatility include wide swings in supply or demand, causing large and abrupt price changes. When such goods are included in the CPI, they may give rise to misleading impressions regarding the rate of inflation. To deal with this problem, economists measure a CORE RATE OF INFLATION, which usually is done by constructing a CPI that does not include food and energy products with highly volatile prices.

NOMINAL INCOME refers to the $-Amount that a person receives, whilst their REAL INCOME refers to the quantity of goods and services that this money will buy. This of course is based on the current price levels, so if these PRICES RISE, the quantity of G&S that can be bought will FALL, in other words, 'THE PURCHASING POWER OF MONEY WILL FALL WHEN PRICES RISE'.  

• Unless the inflation rate is low and stable, it is VERY DIFFICULT FOR PEOPLE YOU PREDICT THE FUTURE REAL RETURNS of any transaction which involves payments at future dates. As shown above, it will DISCOURAGE SAVING AND LENDING ACTIVITIES and ultimately curtail investment and economic growth.

• As we know inflation reduces the 'REWARD FOR SAVNG', thus LOWERING THE INCENTIVE TO SAVE and ENCOURGING MORE SPENDING NOW, which can add to inflationary pressure even more.

• If a country's inflation rate RISES RELATIVE to the rate in other countries then its EXPORTS will become UNCOMPETITIVE, resulting in EXPORT REVENUE FALLING and IMPORT EXPENDITURE RISING, which will LOWER NET EXPORTS.  

• UNCERTAINTY = LOW SAVINGS => LESS INVESTMENT so 'I' FALLS

• LOSS OF INTERNATIONAL COMPETITIVENESS = LESS EXPORTS & MORE IMPORTS so 'NX' FALLS

• Both 'I' and 'NX' are part of AD, so REAL GDP will FALL

• Inflation REDUCES THE PURCHASING POWER OF MONEY, and those with FIXED OR LOW INCOMES will inevitably suffer the most. 

• Not only are their incomes losing their real values but they LACK THE SAVINGS TO SAFEGUARD THEIR WEALTH through stock market investments or real estate, unlike high-income earners.

When prices keep falling, people tend to POSTPONE THEIR PURCHASES, in the expectation that prices will fall further, however, this fall in economic activity means...

Deflation is not a common phenomenon. Whereas it is often the case that the price of a particular good or service may fall over time, it is rare to see the general price level of an economy falling. There are several factors that account for this:

• WAGES DO NOT ORDINARILY FALL: This means it is difficult for firms to lower the prices of their products, as this would cut into their profits, especially since wages represent a large proportion of firms’ costs of production. There are several reasons why wages do not fall easily (labour contracts, minimum wage legislation, worker and union resistance to wage cuts, ideas of fairness, fears of negative impacts on workers’ morale, etc.).

• LARGE OLIGOPIOLISTIC FIRMS MAY FEAR PRICE WARS: If one firm lowers its price, then others may lower theirs more aggressively in an effort to capture market shares, and then all the firms will be worse off. Therefore, firms avoid cutting their prices.

• AVOID MENU COSTS: Firms want to avoid incurring menu costs resulting from price changes, particularly if they believe that the lower prices will prevail only for short periods of time. Therefore, they avoid lowering their prices.

• As already mentioned in the LOSERS section, those who have debt (borrowers) will see the REAL VALUE OF DEBTS INCREASE => LESS CONSUMER SPENDING.

• Deflation also DISCOURAGES BORROWING by both consumers and firms, as the REAL VALUE OF DEBT INCREASES as the price level falls. The result is that business spending ('I') falls, causing aggregate demand to fall. If the economy is already in recession, this will become deeper with falling AD, unemployment increases further, incomes and prices fall further, deflationary pressures increase further, spending and borrowing decrease further, and so on in a downward spiral.

• Deflation DISCOURAGES SPENDING by consumers because they POSTPONE MAKING PURCHASES as they expect that prices will continue to fall, thus REDUCING 'C' and AD, creating cyclical unemployment.

• As mentioned, the VALUE OF DEBT INCREASES, which when coupled with FALLING SALES often results in businesses being UNABLE TO AFFORD REPAYMENTS and defaulting on their loans resulting in them going bankrupt.

Increases their purchasing power, allowing them to save more money as their income increases relative to their expenses.