Exercises: Inflation, deflation and the CPI

Define inflation and deflation. Explain what the Consumer Price Index (CPI) measures.

The CPI was 104.0 last year and is 108.2 this year. Calculate the rate of inflation, correct to one decimal place.

State two causes of demand-pull inflation and two causes of cost-push inflation.

A simplified CPI basket for a student has three items with weights: food 40%, rent 45%, transport 15%. Between two years, food prices rise 5%, rent rises 8% and transport falls 2%.

1. a) Calculate the weighted average price increase (the inflation rate for this basket).

1. b) If the student's income rises by 4%, calculate the approximate change in real income.

1. c) Explain why the CPI may not represent every household equally.

Nominal wages rise by 3.5% in a year while inflation is 5.5%.

1. a) Calculate the approximate change in real wages.

1. b) Explain who gains and who loses from unexpected inflation: savers, borrowers, workers on fixed contracts, and the Government as a debtor.

1. c) Describe how this affects Irish export competitiveness if inflation in Ireland is higher than in trading partners.

A tin of beans cost €1.00 in year 1, €1.05 in year 2 and €1.12 in year 3. Using year 1 as base year (index = 100):

1. a) Calculate the price index for years 2 and 3.

1. b) Calculate the percentage inflation rate between years 2 and 3.

1. c) Explain why economists use an index rather than raw prices.

Discuss the economic consequences of deflation for Ireland. In your answer, consider the effects on consumers' behaviour, debt burdens, investment, and wages, and explain why deflation may be more harmful than moderate inflation.

The CPI measures a fixed basket of goods. Evaluate its limitations as a measure of the change in the cost of living, referring to substitution bias, quality changes, new products, housing costs and differences between household types. Suggest how the CSO addresses some of these problems.

An economy has an inflation rate of 7%. The central bank raises interest rates.

1. a) Explain how higher interest rates are expected to reduce inflation.

1. b) Discuss the likely consequences for unemployment, mortgage holders and investment.

1. c) Evaluate the effectiveness of interest rate policy when inflation is mainly caused by imported energy prices and Ireland is in the eurozone.