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 $\$1,000$ a year ago and now costs $\$1,040$.

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

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?

In the CPI basket, housing and utilities weigh $30\ \%$ and rise by $10\ \%$; recreation 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.

Summarize 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.

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".

During an international energy crisis, the wholesale price of natural gas triples. Observe two measures proposed by different economic advisors to the federal 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 Federal Reserve 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.

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

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

Analyze who loses and who gains with high, unexpected inflation: a retiree with a frozen pension, a borrower with a fixed-rate mortgage, a saver with money in an account at $0.5\ \%$, and the indebted federal government. Justify each case.

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 dollars 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 union contracts demand matching increases.

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

Following an increase in oil prices, year-over-year inflation stands at $8.5\ \%$. In national collective bargaining, labor 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 fueling 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?

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 a small business with a $150,000$ dollars variable-rate loan and a family with $40,000$ dollars saved in certificates of deposit (CDs). 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 platform: "To protect citizens' purchasing power, we will demand that the Federal Reserve 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 Federal Reserve prefers a "safety cushion" close to $2\ \%$ over a strict $0\ \%$ target, considering the room for maneuver of monetary policy in the face of a recession.

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 liter 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 analyzing: 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.