3.

33 Macroeconomic Objectives: Inflation

(Course Guide, p. 38; Dorton, Chapter 20 pp. 291-312)

Definitions:
● Inflation – a sustained (persistent) increase in the
average price level in the economy

● Price Level – the average price of ALL goods and

services in the economy
 3.33 Macroeconomic Objectives: Inflation
(Course Guide, p. 38; Dorton, Chapter 20 pp. 291-312)

● Measuring inflation- (Dorton, pp. 294-296)

Consumer Price Index (CPI)* – measures the change in
the price of a representative “basket” of goods and services
(grouped by categories) consumed by the average
household.
*or Retail Price Index (RPI)
Weighted Consumer Price Index – categories are given a
weight to reflect their relative importance in the average
consumer’s income.
Table 20.2, D, p. 295 UK CPI
Table 20.3, D, p. 296 Changes to the UK CPI

Article: Is the Philippines’ CPI Still Representative Amid the Pandemic?

 3.33 Inflation:

● Inflation Rate: *
( Price Index Year 2 – Price Index Year 1 ) x 100
(Price Index Year 1)
*Calculating inflation using the weighted consumer
price index is a HL only extension topic (pp. 306-308)
which will be tackled later
 3.33 Inflation:
Issues/Limitations in measuring the inflation rate:
(D, pp. 297-298)
● Choice of Weight
– the expenditure pattern of certain groups (or regions) are
different and change over time (e.g. families with young
children vs. a retired couple without children) → what is a
“typical” household?;
– consumers might switch from the goods (in the basket) that
increase in price to substitutes. (substitution effect).

● Statistical Inaccuracies in data collection

– layers of sampling will most likely lead to inaccuracies

● Differences in the way countries measure inflation -

– choice and use of sampling techniques vary which makes
international comparison problematic
 3.33 Inflation:
Issues/Limitations in measuring the inflation rate:
(D, pp. 297-298)
● Price changes that are not sustained - use of the “core”
(underlying) rate of inflation that excludes price
movements in volatile industries (such as agriculture and
energy sectors).
 3.33 Inflation:
Problems/Limitations in measuring the inflation rate:
(Dorton, p. 297)
● Changes in consumption patterns - the “typical”
consumer basket is continually changing. New goods are
added & old goods removed to make it more
representative.
e.g. VCRs, DVD players → Netflix

Vinyl records, cassette tapes, & CDs → Spotify

Pagers, cameras, cell phones & PDAs → smartphones

 3.33 Inflation:
Problems/Limitations in measuring the inflation rate:
(Dorton, p. 297)
● Quality of Goods – goods compared over long time
periods may have major differences in terms of quality.
While the price of a good may be higher (→ interpreted as
inflation), the good is not exactly the same, as the quality
may be better.
e.g. cars, phones, computers etc.
 3.33 Inflation:
Problems/Limitations in measuring the inflation rate:
(Dorton, p. 298)
● Alternative Measures – may be better in predicting
future inflation e.g.

Commodity Price Index – measures the changes in the

prices of factors of production (or raw material prices)
needed by firms

Producer Price Index (PPI) – tracks the prices of goods

as they leave factories and before distributors (wholesalers,
retailers) add profit margins; measures inflation from the
perspective of the producers.
 3.33 Causes of inflation
Demand-pull - inflation which is caused by an
increase in the aggregate demand (AD) in the
economy. Figure 20.1 (p. 298)
→ “ Too much money chasing too few goods“

SRAS
PL2
Average
Price
PL
Level

AD AD2

Y Y2 Real Output
 3.33 Causes of inflation
Cost-push Inflation - inflation caused by an
increase in the costs of production, resulting to a
decrease in Aggregate Supply (AS)
→ “Supply-Shock” (leads to stagflation)
Figure 20.2 (D., p. 298)
SRAS2
SRAS
Average PL2
Price
PL
Level

AD

Y2 Y Real Output
Causes of Inflation
Five major causes of increase in production costs:
(D., p. 299)
● Cost of domestic raw materials (e.g. depletion
of finite natural resources, natural disasters,
market conditions)
● Cost of labor (wages and salaries) → wage-push
inflation
● Price of imported goods (capital, components or
raw materials) → import-push inflation*
● Profits → profit-push inflation
● Taxes - will shift the AS curve to the left
*can also be caused by a depreciation of the
exchange rate
 3.33 Inflation:
Costs of Inflation: (Dorton, p. 292-293)
Redistributive effects:
Loss of purchasing power: People with fixed incomes will
suffer a fall in REAL income.
e.g. daily-wage workers, pensioners, students.
Notes: 1. Cost of Living Allowance (COLA) should ≥ inflation
rate
2. High rates of inflation (i.e. hyperinflation) may make
money literally worthless
Effect of interest rates: Borrowers gain at the expense of lenders
if nominal interest rate < inflation rate

“Inflation is the one form of taxation that can be imposed without

legislation” - Milton Friedman

Effect on savings: inflation discourages savings if real interest rate

(= nominal interest rate adjusted for inflation) is negative.
 3.33 Inflation:
Costs of Inflation:
Effect on Economic Growth - if people save less and instead
buy fixed assets (such as houses and artwork), this will have a
negative impact on investment and economic growth
Uncertainty: Inflation increases the sense of uncertainty in the
business community which might affect the level of investment
and consequently, economic growth.
Labor/Social Unrest: may result if workers feel that their wages
are not keeping up with inflation
Effect on international competitiveness:
If a country has a higher inflation rate than its trading partners,
exports become relatively more expensive than imports (i.e. less
competitive) → may lead to worsening trade balance and
unemployment
Note: “Balanced” Inflation – when relative prices remain
unchanged between countries
Note: Read Table 20.1 p. 293 - “The winners and losers of inflation”
 3.33 Inflation:
Costs of Inflation:
Inefficient resource allocation -

Optional:
Menu cost* - the need for firms to frequently change
price lists
Shoe-leather cost* - the time cost for consumers in
keeping informed of price changes

* Not in the IB syllabus

Disinflation – a falling rate of inflation. (p. 303)

Deflation - the sustained (=persistent) fall in the average

price level (Dorton p. 302)
Two Types: (Dorton p. 303)
1. “Good” Deflation – comes from improvements in the
supply-side (=aggregate supply) of the economy which
leads to a decrease in the average price level and an
increase in real output (→ less unemployment).
See Fig. 20.5
2. “Bad” Deflation – results from a fall in the aggregate
demand (AD) in the economy which leads to a
decrease in the average price level and a decrease in real
output (→ higher unemployment).

Note: Refer to pp. 298, Fig 20.1 & 20.2, but the shifts of the AD
and SRAS are in the opposite direction.
Costs of (“Bad”) Deflation: (Dorton pp. 304-305)
1. Unemployment (Cyclical/Keynesian) – due to low Aggregate
Demand
2. Deferred consumption - consumers hold off purchases as they
anticipate prices to drop further
3. Low consumer confidence, uncertainty
→ deflationary spiral
4. Reduced investment (I) due to lower profits (or losses) and
lower business confidence → may lead to layoffs and
businesses closing down operations (= bankruptcies)
5. Cost to debtors* – the value of debt rises when there is
deflation and nominal interest rates are fixed e.g. housing
loans; business loans more difficult to pay and may further
lower business confidence
6. Policy ineffectiveness - makes use of monetary policy
ineffective (will not be assessed on the 3.33 unit test)
*(similar to redistributive effects - not as important as No. 1-4 )
 3.33 Inflation: Calculations
Dorton, 306-308
● Inflation Rate: *
( Price Index Year 2 – Price Index Year 1 ) x 100
(Price Index Year 1)

*Calculations are required for HL only but SL strongly encouraged

to know this.
Study Table 20.4 Unweighted Price Index on p. 306
Study Table 20.5 Weighted Price Index on p. 307
Practice: with Exercise 20.6 on p. 308
Notes:
● ALL topics from pp. 299-302 (“how might government
attempt to reduce inflation”) will NOT be assessed at this
time. (April, 2023).
● These topics will be discussed under the lessons on Fiscal
and Monetary Policy (3.5 and 3.6).