Exercises: Inflation and purchasing power

Explain what inflation is and how it differs from a price increase in a single product: inflation is a general and sustained rise in almost all prices. Give two examples of each case (gas prices rising due to a fault at a refinery; bread, bus fares, movie tickets, and clothes all rising at the same time).

The CPI is calculated by tracking the "shopping basket" of a typical family: the prices of hundreds of products are recorded every month.

1. a) Explain how this basket allows us to measure inflation.
2. b) Reason why the inflation felt by your grandmother (medicines, doctors, electricity) might be different from yours (leisure, technology, clothes).

The figure shows the inflation of a European country over the last five years: how much prices rose each year. In $2025$, the shopping basket that cost $\$100$ in January cost $\$102$ in December.

1. a) Calculate the inflation for $2025$, which is the missing figure in the chart.
2. b) State in which year prices shot up the most, and explain what happened that year to families whose wages did not increase.

A sandwich cost $\$100$ a year ago and inflation has been $5\ \%$.

1. a) Calculate how much it costs today if it has increased at the average rate.
2. b) Your weekly allowance is still $\$400$: calculate how many sandwiches you could buy a year ago and how many now.
3. c) Use this result to explain what losing purchasing power means, even though "your allowance hasn't gone down".

Iris's mother's salary was $\$30\,000$ per month. This year she received a $2\ \%$ pay raise, but inflation was $4\ \%$.

1. a) Calculate her new salary.
2. b) Calculate the salary she would need to maintain her purchasing power exactly (so she can afford the same as before) and how many pesos short she is.
3. c) Has she gained or lost purchasing power? Explain the difference between getting a pay raise and the cost of living going up.

Deflation is a general fall in prices, and it is also a concern. Explain the chain of events: if people expect everything to be cheaper next month, they delay purchases; shops sell less; businesses make less profit and lay off workers; with higher unemployment, even less is bought. Illustrate this using a fictional local furniture shop in your neighbourhood.

Mateo's grandmother keeps $\$200\,000$ in savings at home, which earns no interest, and her neighbor owes $\$200\,000$ on a loan to be repaid in a year's time. Inflation is $5\ \%$.

1. a) Calculate how much the grandmother's savings will be worth in a year's time measured in "today's pesos" (approximate: they lose $5\ \%$ of purchasing power).
2. b) Explain why inflation benefits the neighbor when repaying the loan (they pay back pesos that are worth less than the ones borrowed).
3. c) Summarize what inflation does between savers and borrowers: who loses out, who wins, and why.

Analyze the following two financial press headlines:

• Headline A: "The rise in the international price of natural gas and maritime shipping rates pushes up manufacturing costs for European industry."

• Headline B: "The extraordinary increase in direct aid and accumulated savings triggers a surge in travel and dining bookings, allowing hotels and restaurants to raise prices in the face of an avalanche of customers."

1. a) Classify each case with reasoned arguments according to the type of inflation (demand-pull or cost-push) and describe the mechanism through which prices end up rising in each headline.
2. b) Predict the effects of an aggressive interest rate hike by the European Central Bank if applied against the situation in Headline A: will it succeed in making imported gas cheaper? What impact will it have on economic activity and business employment? Justify why in this case the central bank faces a dilemma.

In a televised debate, a panelist argues: "The European Central Bank's goal of maintaining inflation around $2\ \%$ is detrimental to citizens; the ideal situation would be a continuous annual deflation of $2\ \%$, because that way money would be worth more each year and we would be richer."

1. a) Rebut the panelist's position by explaining the mechanism of the deflationary spiral: predict what would happen to households' consumption decisions and businesses' investment and hiring decisions if they knew for certain that prices will be lower next year.
2. b) Justify why central banks consider that moderate and predictable inflation (around $2\ \%$) is a sign of a healthy economy, distinguishing it from both deflation and runaway inflation.