(3) (a) Distinguish between inflation and disinflation.
Inflation – refers to a sustained increase in the Average Price Level – or the idea that inflation is an increase in the price of goods and services.
Disinflation – refers to a decrease in the rate of increase of the Average Price Level or a decrease in the rate of inflation.
(b) (i) Calculate the inflation rate for 2013 and for 2015 for Country A.
Rate of inflation formula = (New-old)/old x 100
(156.28 – 151.58) / 151.58 x 100 = 3.10
(156.07 - 158.93) / 158.93 x 100 = -1.799 or -1.80
(ii) Identify the year that Country A experienced disinflation.
2014 as the Rate of inflation in 2013 was 3.1 % while the Rate of Inflation in 2014 was 1.7% (There was an increase in inflation of 1.7% but the rate of that change was less than the previous year) = Disinflation
2015 was deflation as the PL actually decreased from the previous year.
(c) (i) The Consumer Price Index (CPI) is a weighted price index. Outline one reason why weights are used in the construction of the CPI.
Weights reflect the proportion of total spending allocated so that increased prices in goods with a larger weight lead to a more significant effect on the inflation rate than goods with a smaller weight.
Or
Increased prices are not of equal significance to the typical consumer so weights are used to reflect the relative importance of each good.
(ii) Determine the percentage change in the CPI of Country A between the base year and 2013.
Assuming that 2012 is the base year with a CPI of 100 (as the base year’s CPI is always 100) then the change in the CPI (inflation) from 2012 to 2013 was an increase in prices of 56.28%
(d) Outline how a producer price index may prove useful in predicting future inflation.
A producer price index measures the costs of bought-in raw materials and intermediary products (factors of production) and that current increases/ decreases in production costs are likely to lead to increases/decreases in consumer prices in the future.
(e) Explain two reasons why governments attempt to avoid deflation.
· Deflation induces households to postpone purchases, further decreasing spending which in turn further decreases consumption expenditures and thus AD and leads to further decreases in real output.
· Real debt of households/firms increases so that consumption expenditures further decrease (or banks accumulate bad loans increasing the likelihood of a bank crisis).
· Deflation being typically caused by a fall in AD leads to an increase in cyclical unemployment.
· The real cost of government debt servicing increases, putting pressure on other areas of government spending.
· Deflation puts downward pressure on firms’ profits because after buying raw materials and making goods, price might have fallen below the costs of the goods/ raw materials; therefore firms are less likely to expand.
· Higher real interest rates or lower business confidence will discourage firms from borrowing for investment projects.
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