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 $\$20\,000$ a year ago and now costs $\$20\,800$.

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

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.

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.

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.

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.

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 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.

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 $150,000$ pesos variable-rate loan and a family with $40,000$ pesos 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).