monetary policy and the price level Flashcards
inflation
a steady and persistent increase in the general level of prices.
It is the rate at which your money loses its ability to buy goods/services
deflation
there is a general decrease in the average level of prices
very damaging to an economy
effects of deflation
-consumers may postpone buying goods/services as they expect prices to continue to fall
therefore demand has fallen, which affects employment and growth
measure of inflation
simple price index
price in any year / price in base year x100
composite price index
examines changes in the general price level ie many goods
takes into consideration the importance of the amount of money spent on each good (weights)
steps of finding the composite price index
- choose a base year and let all the prices equal to 100
- select the goods and find their prices in all years
- construct a simple price index for each good
- multiply the simple price index by the weight
- add to get the composite price index for the current year
consumer price index
measures the overall change in the prices of goods and services that people typically buy over time.
It does this by collecting approx. 53,000 prices every month and comparing these to the corresponding prices from the previous month
the household budget survey
carried out every 5-7 years to find out the fraction of income spent on items
carried out to get accurate details of consumer spending patterns
economic uses of CPI
-maintaining the real value of social welfare payments eg pensions
-international comparisons: comparing our rate of inflation with abroad shows whether
our international competitiveness is improving or disproving
government can improve Irish international competitiveness by
negotiating wage agreements reducing utility charges reducing VAT reducing employers PRSI improving infrastructure
precautions to take when using CPI
- index of only the average consumer
- not a cost of living index
- lags behind consumer trends and fashions
- static weights
- quality changes in products
what factors cause inflation
demand pull factors:
-if aggregate demand is greater than a. supply, prices go up
cost push factors:
-increase in the cost of production -> pass this on to selling price
imported inflation:
-cost of imported raw materials increases -> pass this on to selling price
government induced inflation:
-gov. decided to increase VAT, or reduces income tax. which increases demand pull inflation
harmonised index of consumer prices
compares the rates of inflation in euro areas, the EU, the European economic area and other countries
calculated in a harmonised approach, ie same method for each country
similarities between CPI and HICP
purpose:
-both measure the change in the average level of prices of a fixed basket of consumer goods and services
reference population:
-includes all private households, foreign tourists on holidays and all institutional households
methodology:
-both use the same methods in compiling and aggregating the component price indices, following EU regulations by Eurostat
differences between CPI and HICP
date of introduction:
CPI march 1922
HICP 1996
measure of consumer price inflation:
CPI is the official measure in Ireland
HICP enables international comparisons
base reference period:
CPI: december 2011 = 100
HICP: 2015 = 100
monetary policy
the way in which the central bank affects the amount of money in circulation
ECB role
maintain price stability in the euro area and so preserve the purchasing power of the single currency
how does the ECB implement monetary policy within the eurozone countries
- monitors the growth of money supply
- engages in open market operations
- sets interest rates
- uses standing facilities: marginal lending facility and deposit facility
- ensures minimum reserve requirements
demand pull inflation
due to:
- goods cannot be manufactured/imported quick enough to meet demand
- unexpected increase in consumer confidence
- firms with monopoly power take advantage and increase prices
cost push inflation
due to:
- increased wage demands due to the minimum wage/social partnership agreements
- increased prices for imported raw materials
- imported inflation
- value of the euro falls
- increased cost of homemade raw materials
- increased costs of production
factors that cause inflation
-imported inflation
-government induced inflation due to:
increased VAT
knock on effect for wage increases
lowering income tax
economic effects of inflation
production may be encouraged consumption may be encouraged lower standard of living increase in unemployment borrowing is encouraged saving is discouraged
remedies to reduce inflation
-fiscal policy: increase direct/indirect taxation encourage savings reduce gov. spending -monetary policy availability of credit interest rates -partnership agreements for low pay increases social welfare/pensions
dangers of hyperinflation
money loses its value when alternative methods of exchange are used (barter or foreign currency)
deflation
there is a general decrease in the average level of prices
causes a decrease in demand/investment
deflation may be caused by
- over supply in relation to demand
- a sudden drop in demand, investment, gov spending
- persistent unfavourable balance of payments
positives of deflation
- increase in the purchasing power of money
- gov can save money on capital projects
- increased national competitiveness
benefits of price stability
- demand for wage increases wont be as urgent as purchasing power isn’t falling
- OAPs and those on fixed incomes will have their purchasing power maintained, managing their finances better
- savings may increase, particularly if the rate of inflation is higher than the rate of savings
