Exercises: Inflation and price stability

Explain what inflation is and which index measures it in Spain. What does the CPI "shopping basket" contain and what is it used for?

The shopping basket used to measure the CPI cost $1.000\ \text{€}$ a year ago and now costs $1.040\ \text{€}$.

1. a) Calculate the annual inflation rate.
2. b) Explain what this figure means for a family's wallet.

Summarise in one sentence each of the three classic explanations of inflation: demand-pull, cost-push, and growth of money supply. Give an example of each.

"The September CPI rose by $3\ \%$ year on year." Explain exactly what that sentence means (compared with what moment?) and why the CPI is used as a reference for raising rents, pensions or wages.

What is core inflation (the CPI without energy or unprocessed food)? Explain why analysts watch it so closely: what noise does it remove and what trend does it show better?

The CPI reference basket cost $800\ \text{€}$ a year ago and now costs $824\ \text{€}$.

1. a) Calculate the annual inflation rate.
2. b) If your family spends $2.000\ \text{€}$ a month on products similar to those in the basket, estimate how much more they will pay per month with that inflation.

Distinguish inflation, disinflation and deflation with these fictitious data: prices rise by $4\ \%$ one year, by $1\ \%$ the next and fall by $1\ \%$ the third. Assign the correct term to each year and explain the difference between "rising more slowly" and "falling".

Topic challenge. The CPI (Consumer Price Index) measures how the prices of the goods and services consumed by an average household evolve.

1. a) Which public body calculates the CPI in Spain and how does it do it? Briefly describe the procedure (price collection and use of the shopping basket).

1. b) Explain why it is important to update the basket when consumption habits change.

What will be assessed: that you correctly identify the body, that you explain that prices are collected for a basket of goods and services weighted according to their share in household spending, and that you justify with an example why an outdated basket would distort the measurement of inflation.

Carla's salary rises by $2\ \%$ and inflation is $5\ \%$.

1. a) Calculate Carla's loss of purchasing power.
2. b) Explain what she should ask for in salary negotiations to avoid losing purchasing power.

The figure shows the annual inflation of an imaginary country over eight years.

1. a) Identify the year with the highest inflation and the years of price stability.
2. b) Was there deflation in any year? Explain what would have happened to prices that year.

Analyse who loses and who gains with high, unexpected inflation: a pensioner with a frozen pension, a borrower with a fixed-rate mortgage, a saver with money in an account at $0,5\ \%$, and the indebted state. Justify each case.

A pensioner's basket (lots of healthcare, food and heating) becomes $6\ \%$ dearer while the general CPI rises by only $3\ \%$.

1. a) Explain how it is possible for "her" inflation to be double the official one: what role do the basket's weightings play?
2. b) Reason what it means that inflation is not the same for everyone and what implication that has for raising pensions with the general CPI.

In the CPI basket, housing and utilities weigh $30\ \%$ and rise by $10\ \%$; leisure weighs $10\ \%$ and falls by $5\ \%$; the rest ($60\ \%$) does not change.

1. a) Calculate the approximate change in the total CPI by weighting each part.
2. b) Explain why the goods with the most weight in the basket dominate the final inflation even though they rise less than others.

Your deposit yields $2\ \%$ a year and inflation is $4\ \%$.

1. a) Calculate the approximate real interest rate (nominal minus inflation).
2. b) Explain what the real interest rate is and why it is the one that really matters to the saver: what happens to your purchasing power if it is negative many years in a row?

Spain imports almost all the oil and gas it consumes. When those prices soar worldwide, inflation rises here without the Spanish economy being overheated.

1. a) What is imported inflation? Explain it with this example.
2. b) Reason why a euro country cannot respond by devaluing its currency and what instruments it does have (energy saving, targeted aid, European negotiation).

After two years of high inflation, firms already set prices assuming it will keep rising, and collective agreements demand matching increases.

1. a) Explain what inflationary inertia is and how expectations feed it.
2. b) Reason why the ECB insists on "anchoring expectations" and what that has to do with its credibility: what happens if people do not believe it?

During an international energy crisis, the wholesale price of natural gas triples. Observe two measures proposed by different economic advisors to the government to curb the impact on final prices:

• Proposal A: Subsidize $50\ \%$ of the energy bill for industries and households financed by public debt.

• Proposal B: Have the Central Bank immediately and aggressively raise interest rates to contract aggregate demand.

1. a) Analyze the feasibility and secondary effects of Proposal A: does it solve the cause of cost-push inflation, or does it only postpone the problem? Justify the impact on the deficit and future consumption.
2. b) Evaluate Proposal B: why can using monetary policy against a supply shock lead to stagflation? Explain which macroeconomic variable is sacrificed in the short term.
3. c) Predict which sectors of the economy will pass on cost increases to their final prices more quickly and which will be forced to reduce their profit margins. Justify your answer based on the price elasticity of demand for their goods.

A TV commentator claims: "Raising interest rates to curb inflation is nonsense: it makes loans more expensive for businesses, increasing their financial costs, and therefore companies will raise prices even more so they don't lose money."

1. a) Rebut this argument by explaining the complete transmission channel: why, despite the temporary increase in financial costs, does raising rates ultimately curb the generalized rise in prices?
2. b) Imagine an SME with a $150.000$ € variable-rate loan and a family with $40.000$ € saved in fixed-term bank deposits. Predict how an interest rate increase from $0,5\ \%$ to $4\ \%$ affects the spending, investment decisions, and net worth position of each.
3. c) Justify why controlling inflation through interest rates is said to have an asymmetric distributive cost in society (who bears the greatest sacrifice versus who benefits).

A political party includes the following proposal in its manifesto: "To protect citizens' purchasing power, we will demand that the ECB set an inflation target of $0\ \%$, and we will even reward falls in the CPI of $-1\ \%$ or $-2\ \%$ per year so that things become increasingly cheaper".

1. a) Use the concept of a "deflationary spiral" to predict what would happen to durable consumption decisions (housing, cars) and business investment plans if prices were to fall continuously by $2\ \%$ per year.
2. b) Explain the problem of downward wage rigidity and the real debt burden in a deflationary environment: why does an inflation rate of $0\ \%$ or a negative one tend to destroy jobs and trigger bank default rates?
3. c) Provide a technical justification for why the ECB prefers a "safety cushion" close to $2\ \%$ over a strict $0\ \%$ target, considering the room for manoeuvre of monetary policy in the face of a recession.

Following an increase in oil prices, year-on-year inflation stands at $8,5\ \%$. In national collective bargaining, trade unions demand an $8,5\ \%$ wage increase for all workers, while employers' associations state that, if wages rise at that pace, they will have to increase their selling prices by an additional $4\ \%$ to avoid bankruptcy.

1. a) Demonstrate using a causal reasoning diagram how this stance leads to so-called "second-round effects" and a wage-price spiral. What would happen to the country's external competitiveness if its trading partners maintain an inflation rate of $2\ \%$
2. b) Design the foundations of a quantitative and equitable "incomes pact" for this year: determine what percentage of wage increase and what commitment regarding corporate profit margins you would propose to share the cost of the energy shock without fuelling the spiral.
3. c) Anticipate the "free-rider" problem in this pact: what perverse incentive does a specific sector have not to comply with the agreement if all the others do abide by it?

In a country with a chronic public deficit of $12\ \%$ of GDP, the Minister of Economy proposes: "Instead of borrowing from banks or raising taxes, we will amend the law so that the Central Bank directly issues money and pays for all public works and State payrolls. Since issuing money does not generate debt, there will be no interest to pay".

1. a) Rely on the Quantity Equation of Money ($M \cdot V = P \cdot Y$) to refute the minister's statement. Explain what will happen to the velocity of money circulation ($V$) once citizens anticipate that the money supply ($M$) doubles periodically.
2. b) Describe the three basic functions of money (medium of exchange, unit of account, and store of value) and predict how each of them collapses when the monthly inflation rate exceeds $50\ \%$.
3. c) Justify why the Treaty on the Functioning of the European Union strictly prohibits direct monetary financing of governments and shields the ECB's independence. What electoral conflict of interest does this rule attempt to avoid?

Analyse the following table showing the evolution of a country's CPI (Base 2020 = 100):

A newspaper headline reads: "Inflation plummets to $2,0\ \%$: prices return to normal". At the same time, a survey shows that $85\ \%$ of families claim that filling the shopping basket is harder than ever.

1. a) Use the data in the table to refute the newspaper headline. What conceptual confusion does the journalist make between "inflation rate" and "price level"? Calculate the cumulative increase in prices between 2020 and 2023.
2. b) Justify from the perspective of economic psychology why citizens' perception of inflation tends to be higher than the official CPI (consider the frequency of food purchases and the asymmetry in remembering price increases versus decreases).
3. c) If you were the director of the National Statistics Institute, design a proposal for a complementary indicator or a graphical way of presenting the data to citizens to avoid misunderstandings about the evolution of the cost of living.

The INE calculates the CPI using a fixed shopping basket. Analyse two real-world measurement cases in an economy:

• Case 1: The price of beef rises by $30\ \%$, while that of chicken remains constant. Many households substitute beef with chicken, but the fixed weighting of the CPI continues to assume that they consume the same amount of beef as three years ago.

• Case 2: The new laptop model costs $800$ €, exactly the same as the previous year's model, but it has twice the memory, three times the speed, and a battery that lasts twice as long. The CPI records a $0\ \%$ change for this product.

1. a) Interpret the error made by the CPI in each case: is it overestimating or underestimating real cost-of-living inflation in Case 1 and Case 2? Justify your answers by distinguishing between substitution bias and quality bias.
2. b) If state pensions are revalued annually according to the official CPI and it shows a cumulative upward bias of $0,6$ percentage points each year, predict and assess the long-term impact on the sustainability of public spending and the relative purchasing power of pensioners compared to other workers.

In a eurozone country, the following macroeconomic data are recorded simultaneously:

• Unemployment rate: increases over one year from $11,5\ \%$ to $13,8\ \%$.

• Headline CPI: $+6,4\ \%$ year-on-year (caused by a rise in the price of imported raw materials).

• Core inflation (excluding energy and unprocessed food): $+2,1\ \%$ year-on-year.

1. a) Interpret the gap between headline inflation ($6,4\ \%$) and core inflation ($2,1\ \%$): which of the two figures should primarily guide the ECB's interest rate decision? Predict what would happen to employment if the ECB aggressively raises interest rates to curb headline inflation.
2. b) The national government is debating two fiscal responses to this crisis:

• Option 1: A blanket subsidy of 20 cents per litre of fuel for all consumers.

• Option 2: A direct cash transfer targeted exclusively at the $20\ \%$ of lowest-income households.

Critically compare both options by analysing: their cost to the public deficit, their effect on incentives for energy saving, and their risk of prolonging inflationary pressures.

1. c) Design and justify the optimal combination of monetary and fiscal policy (policy mix) that you would recommend to avoid worsening unemployment while protecting the purchasing power of the most vulnerable groups.

Topic Challenge. Become an advisor to the European Central Bank (ECB) to assess price stability in Spain and propose the next monetary policy decision.

Follow these three phases:

1. Data collection: Go to the INE website (ine.es) and write down the latest year-on-year CPI figure. Then, check the main official interest rate currently in force on the Banco de España or ECB website.

2. Real-world diagnosis: Briefly interview two adults around you to find out how they perceive the rise in prices in their shopping basket or in their loans, and compare their perception with the official rate obtained.

3. Monetary policy report: Prepare a one-page executive report with a comparative table (CPI vs. $2,0\,\%$ target) and a reasoned proposal: recommend whether the ECB should raise, lower, or maintain interest rates, explaining the transmission mechanism that will affect savings, consumption, and final inflation.

Assessment criteria:

• Thoroughness in obtaining updated real data from the INE and the ECB.

• Understanding of the interest rate transmission mechanism to the real economy.

• Consistency and macroeconomic justification in the final proposal.