Problems with Price Indices:

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    Problems with Price Indices:

    • Over time typical household basket of goods and services will change.
    • CPI needs to take account of this, but deciding how and when to make them can be difficult.
    • Changes due to:
      • Fashion and taste
      • Introduction of new goods and services
      • Change in population and household size due to migration, birth/death rates, marriage timing and numbers etc.
      • Similarly CPI needs to take into account changes in quality of goods and services over time, how and where households buy goods and services such as internet and new shops.
      • International comparisons of CPIs are hard to make due to different household compositions and spending patterns.
      • Argued that exclusion of food, energy, house prices and income taxes means CPI cannot accurately measure change of living cost.

    Inflation

    • Economists today tend to agree main cause of inflation is ‘too much money chasing too few goods.’
    • This means people are able to increase spending on goods and services faster than producers can supply goods and services, boosting aggregate demand and forcing prices up.
    • A government can allow supply of money to increase in an economy by issuing more money or allowing banking system to create more credit – lending more to people and firms.
    • A government may do so to :
      • Increase total demand in economy to reduce unemployment.
      • In response to increase in demand for goods and services for goods.
      • In response to workers demand for higher wages, or rise in other production costs.
      • As money supply rises, people’s purchasing powers rise and inflation can occur.
      • To stop excessive inflation, a monetary rule government’s should follow is to only allow supply of money to expand at same rate as increase in real output or real GDP over time.
      • If money supply increases faster than output, then inflation will occur.
      • Stagflation – when inflation and unemployment are both high and increasing – often due to rising living costs causing increased demand for higher wages and less labour demand.

    Causes of inflation

    • Increase in Money Supply – an increase in money supply would increase the spending

    power of the average consumer, thus increasing demand and hence pushing up prices. This  then causes inflation.

    • Demand Pull Inflation – When aggregate demand is increased, firms are no longer able to

    meet demand in production and thus prices inflate. To finance this, firms may borrow more or money supply increased.

    • Cost Pull Inflation – When the cost of producing goods is increased, firms may want to offset these increased costs to consumers to keep a certain level of profit, thus the extra cost is added to price of the good or service, causing inflation. Wage Price Spiral is when workers demand higher and higher wages, causing cost push inflation and prompting them to ask for higher wages again.
    • Imported Inflation – rising prices in one country may be exported to another country through international trade in many different goods and services. Many countries have been able to enjoy stable inflation as China’s large supply of goods and services is produced through cheap labour.

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