Assignment Example on Consumer Price Index and Inflation

What is the Consumer Price Index (CPI) and how is it determined each month? How does the Bureau of Labor Statistics (BLS) calculate the rate of inflation from one year to the next? What effect does inflation have on the purchasing power of a dollar? How does it explain differences between nominal and real interest rates? How does deflation differ from inflation? (20)

ANSWER:

The Consumer Price Index is a measure, widely is used in examining the weighted average prices of goods and services which vary from: transportation, food, medical care.

The CPI can be viewed as a market basket sampling of goods that consumers typically purchase. Various Prices of goods in the market basket are collected each month then weighted by the significance of the good in the basket and finally averaged to form the price level. It is determined each month by updating the composition of the market basket every 2 years. The results of the CPI are then used to report the inflation rates each month and each year. Calculations are then done by the taking price for each item in the predetermined number of goods and averaging them using the formula of weighted mean (sum of products of prices and their weights/sum of the weights.)

CPI of the particular year = Price of the most recent basket in the particular year x 100

Price estimate of the market basket in every two consecutive years

Example:

WEIGHT / NO. OF ITEMS / WEIGHT X I

160 / 4 / 640

105 / 4 / 420

80 / 1 / 80

225 / 1 / 225

Study shows that, The Bureau of Labor Statistics calculates the rate of inflation from one year to the next using the CPI calculator which subtracts CPI for the previous year from the CPI for the current year, and then divides this difference by the CPI for the previous year(David, 1996). This value when multiplied by 100 gives us the percentage change in the price level of goods for a certain year.

Formula 1:

CURRENT INFLIATON= CURRENT CPI- CPI FOR PREVIOUS YEAR

CPI OF PREVIOUS YEAR

Formula 2:

PERCENTAGE CHANGE IN PRICE LEVEL=INFLATION X 100

EXAMPLE:

The CPI in the year 1996 was 98.70. The CPI for 1997 was 100.calculate the inflation.

INFLATION= CURRENT CPI- CPI FOR PREVIOUS YEAR

CPI OF PREVIOUS YEAR

=100-98.70

98.70

=0.01317

Inflation as shown by research increases consumer prices over a period of time and causes a reduction in the consumer purchasing power of the dollar. There is a distinct difference between the nominal and real interest rates in that: real interest rate is clear distinction of the two; nominal interest rate and inflation.

Therefore, current inflation = Real interest rate - nominal interest rate.

An example is a nominal interest rate of 4% and a real interest rate of 3% which causes an inflation of about 1%.

There are clear differences between nominal and real interest rates. Their difference is mostly has to do with the rate of inflation in CPI. Given a nominal rate of 10% with a 6% inflation rate, this will mean that real interest rates are approximately about 4%.

There are different phases in the economy whereby goods and services are in very high demand, and as a result producers are not able to produce enough goods to cater for the necessity of all beings, which creates a drop in availability of the goods and services, and this in the long run results to inflation. Scenarios like when the Consumers are willing to pay more for the items they want, causes manufacturers and service providers to charge more than they would do under normal circumstances and this can be beneficial to some industries but to others, loss in shares might be quite inevitable. Moreover, Supplies can decrease for many reasons: like a natural disaster in the form of a disease and aggressive weather can wipe out a food crops or global warming which may affect food processing industries.

On the other hand, a phenomena like Deflation occurs when too many goods are available or even when there is not enough money circulating among the people in a given place or state in order to purchase those goods. Research shows that if a particular type of cereal becomes highly popular, other manufacturers will automatically start to make a similar cereal so as to compete. As a result, many cereal manufacturing companies have more of that cereal type than they can retail, so they must drop the price to sell the product, which in this case is the cereal.

Owing to this, companies find themselves stuck with too much inventory the need to cut costs somewhere, a situation which often leads to layoffs of their staff leading to unemployment and lower living standards to avoid getting bankrupt(Blanchard, 1989).

Distinguish between demand-pull inflation and cost-push inflation. Which of the two types is most likely to be associated with a negative GDP gap? Which with a positive GDP gap, in which actual GDP exceeds potential GDP? What is core inflation? Why is it calculated? (30)

Answer

Excessive demand of goods and services often leads to a condition termed Demand-pull inflation. When the people as a whole get more money, or if they have a high disposable income, they become comfortable to pay more for goods and services hence more goods and services are produced. Many economists argue that the situation is that there is more money "chasing" the same amount of goods and services because there is more cash circulating among the population than the amount of goods and services (David, 1996). This is what is to be blamed as in turn it causes shortages of goods and services with the prices of the goods and services also on the rise. Disruptions in supply can also cause Cost-push inflation together with problems like increased Price of production of goods and services which have adverse implications on the common citizen. Such is the root cause of inflation. Changing costs in the price of inputs may also increase due to the likelihood of increase in wages and most certainly raw materials to produce the goods and to give the desired service.

Continuous rise in price of inputs decreases the short run aggregate supply which in turn increases the price level of the goods and services. Practically, whenever there is a rise in the price of oil all production becomes more expensive. When there is a rise in the production cost, Cost push inflation is sure to follow together with its associated negative GDP which forces many people to reduce spending and output generally. It is only in rare cases that Demand pull inflation exceeds its potential and this is experienced when aggregate spending is quite strong and rising. Such situations in the economy produces above potential and severe resource scarcity occurs driving up prices and this is at which time taxes go up. The Core inflation represents the future trend in the price level of items as it clear when there is sudden price change of goods and services minus food and energy. Evidently, it represents the most accurate picture of underlying future inflation trends. Hence Core inflation is seen as an act of means to get an accurate measure of the current inflation trend, which is measured at a frequency of a year at most. When there is a large interval in the inflation beyond twelve months, a proper and more constructed core measure should give out the same quantitative estimate of current inflation as the headline index does. In a period of several years, headline and core inflation should be the same.

Illustration

3. Explain how an increase in your nominal income and a decrease in your real income might occur simultaneously. Who loses from inflation? Who gains? (10)

In practical scenarios, when the cost of living increases faster than a persons nominal income, their real income decreases. This can result in their nominal income increasing and their real income decreasing simultaneously. Take for example: if a persons nominal income increases by 20% and their current cost of living increases by 25%, then their real income decreases to 96% of the original real income, which would result to a 4% drop as shown in the example below:

((120/1.25)-100)=4.

Illustration

People who are negatively affected by inflation are the people whose incomes do not increase at the rate of inflation, but do so at a slower rate than the inflation rate or similarly, it is on those whose incomes are fixed in nominal terms. According to David, the economy as a whole loses in terms of the comfortable living standards of its members because of the increased loss in production caused when people are affected by inflation.

4. Explain how hyperinflation might lead to a severe decline in total output. (10)

Answer

There are times when the economy is facing extremely high inflation, and its at such times that saving makes no sense to most people.it is no wonder that the only functional thing to do with cash is to expend it before its value significantly falls. Many people as a result try to spend as fast as possible, speeding the inflationary spiral and this forces them to spend more time trying to figure out what goods are most likely to go up fast in price. More and more than People turn away from productive activity, because wages and salaries are not able to keep up with inflation. Instead, most of their time is spent speculating, transferring goods already in existence and producing nothing useful. The work Production and Investment in productive capital does decrease and unemployment spreads fast eventually because survival now will depend on ones own wits.

This in details offers to explain why everyone trying to spend as fast as possible will eventually speed the inflationary spiral and this in turn drives people to expend more and more time straining to figure out what goods are most likely to go up fastest in price. Fo this reason, more and more people will opt to engage in simple activities that do not force them consume the little energy they have left, and it is not surprising that a study showed that in such moment ,the level of insecurity is almost at the maximum as people lack things to distract their minds.

Illustration to show effects of hyperinflation

4. If your nominal income rose by 5.3 percent and the price level rose by 3.8 percent in some year, by what percentage would your real income (approximately) increase? If your nominal income rose by 2.8 percent and your real income rose by 1.1 percent in some year, what must have been the (approximate) rate of inflation? (15)

Answer

Percentage variation in real income = percentage variation in nominal income - inflation rate

Percentage change in real income = 5.3%-3.8%

Percentage change in real income = 1.5%

Formula 2

Rate of inflation=percentage change in nominal income percentage change in real income

Rate of inflation=2.8%-1.1%

Rate of inflation=1.7%

5. Suppose that the nominal rate of inflation is 4 percent and the inflation premium is 2 percent. What is the real interest rate? Alternatively, assume that the real interest rate is 1 percent and the nominal interest rate is 6 percent. What is the inflation premium? (15)

Answer

Real interest rate signifies an interest rate that has been adjusted to remove the effects of price rises and to replicate the real cost of funds to the borrower, and the real yield to the lender

Inflation premium can be viewed as the amount that the interest rate is raised to in order to cover effects of anticipated inflation.

According to fishers principle, the nominal rate of interest will adjust so that it is equal to the nearly constant real rate plus an inflation premium.