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Inflation Measurement and Causes

Arsalan Islam Misha Arshad

Noor Ali Barkat Ali


Qazi Umair
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Defining inflation
Inflation is a sustained increase in the average price level of a country. The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index.

A sustained fall in the general price level is called deflation in this situation, the rate of inflation becomes negative.

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Causes of Inflation
Any inflation that results from an increase in demand is called demand-pull inflation Caused by
Increased Incomes Decreased income taxes Increased optimism about the future Decreased tendency to save

Consumers expect prices to rise in the future


More money in the economy
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Causes of inflation
Any inflation that results from a

decrease in supply is called cost-push inflation.

Caused by
Increased costs of raw materials
Increased Wages Failure to replace capital goods as they age, reducing its productivity, or increasing

its maintenance costs

Falling Productivity of workers


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Measuring Inflation
The CPI can be thought of as an imaginary basket of selected goods and services bought by a typical capital city household. The CPI is merely a measure of the changes in the price of this basket of goods and services. The price of the CPI basket in the base (first) period is given a value of 100 and the prices of subsequent periods are compared against the base year.
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Measuring Inflation
For example, if the price of the basket had increased 15% since the base year, the CPI would read 115, if the price had fallen by 15% since the base year the CPI would be 85.

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Measuring Inflation
The eight groups of the CPI are as follows:
Food Clothing Housing Education and Recreation

Transportation
Tobacco and Alcohol Health and Personal Care

Household Equipment and Operation

Compilation of the CPI involves a quarterly survey of a basket of goods and services representing a high proportion of household expenditure.

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Constructing the CPI Index


Period 1 Period 2 Weight Price WXP Price WXP 40 0.65 26 0.80 32 30 0.70 21 0.80 24 20 1.15 23 1.15 23 10 1.00 10 1.10 11 100 80 90 100 112.50
8

Commodity Food Clothing Housing Recreation Total Price Index


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Causes of Inflation
Two Shifts
An increase in demand ( a shift in the demand curve to the right) A decrease in supply (a shift of the supply curve to the left) Price ($)
P1 Pe

Price

($)

S 1S
P1 Pe

D1

D
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Qe Q1 Q1 Qe

D Quantity

Quantity

What are the main causes of inflation?


Demand pull inflation Cost push inflation

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Demand-pull inflation
Occurs when there is excess AD i.e. when there is a positive output gap (actual GDP > Potential GDP) Businesses respond to high demand by raising prices to increase their profit margins Demand-pull inflation is associated with the boom phase of the cycle (when SRAS becomes inelastic) The main causes of demand pull inflation
Very fast growth of demand for credit / borrowing

High levels of consumer spending

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A Classical AD/AS diagram


Price Level LRAS

What would happen if there was an increase in AD in the SHORT RUN?

AD

Y1

Real National Output

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A Classical AD/AS diagram


Price Level LRAS

SRAS

How can an economy operate beyond its Full employment level?

AD1 AD

Y1

Y2

Real National Output

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A Classical AD/AS diagram


Price Level LRAS

SRAS

In the SR the economy can work overtime, at a slightly higher cost (overtime)
AD1 AD

Y1

Y2

Real National Output

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Draw a Classical AD/AS diagram


SRAS2 Price Level LRAS

SRAS

AD1 AD

In the LR, workers are not willing to sacrifice Leisure time for more overtime. But still have high wage expectations. demand pull inflation

Y1

Y2

Real National Output

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Main causes of demand pull inflation


A depreciation . A reduction in direct or indirect taxation How can each of these cause inflation?

Rapid growth of the money supply


Rising consumer confidence

Faster rates of economic growth in other countries


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Main causes of demand pull inflation


A depreciation of the exchange rate increases the price of imports and reduces the foreign price of exports A reduction in direct or indirect taxation - consumers will have more disposable income causing demand to rise Rapid growth of the money supply as a consequence of increased bank and building society borrowing Rising consumer confidence and an increase in the rate of growth of house prices

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Cost push inflation

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Cost Push Inflation


Occurs when costs of production are increasing

Causes:
External shocks (commodity price fluctuations) A depreciation in the exchange rate Acceleration in wages

Leads to inward shift in SRAS curve


Firms raise prices to protect their profit margins better able to do this when market demand is price inelastic

Wages often follow prices


A rise in inflation can lead to rising inflationary expectations
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Classical AD/AS diagram


Price Level LRAS SRAS2

SRAS1

What would happen if there was an inward shift of the SRAS?


AD

Y2

Y1

Real National Output

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Cost push inflation falling SRAS


Price Level LRAS

SRAS2

SRAS

Yfe

Real National Output

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Illustrating cost-push inflation


Price Level LRAS

P2 Pe SRAS2

SRAS AD1

Y2

Y1

Yfe

Real National Output

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Consequences of growing inflation

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Costs and Consequences of Inflation


Money loses its value and people lose confidence in money as the value of savings is reduced Inflation can get out of control - price increases lead to higher wage demands as people try to maintain their living standards. This is known as a wage-price spiral. Consumers and businesses on fixed incomes lose out because the their real incomes falls - employees in poor bargaining positions lose out
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Costs and Consequences of Inflation


Inflation can favour borrowers at the expense of savers because inflation erodes the real value of existing debts Inflation can disrupt business planning and lead to lower capital investment

Inflation is a possible cause of higher unemployment in the long term because of a lack of competitiveness
Rising inflation is associated with higher interest rates this reduces economic growth and can lead to a recession
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