Module Title: Assignment Title: Level: Weighting: Assessment Technique: Handout Date: Submission Date:

Applied Economics Assignment 2 5 30% Typed 24 January 2012 06 March 2012

Introduction
As part of our economics module we where asked to outline the effects of inflation with reference to Ireland. We must also show an understanding of how the consumer price index is calculated and why it is needed. By completing this assignment we hope to gain a thorough understanding of how inflation and the CPI work and why they must be monitored. Inflation is defined as a continuous rise in the general level of prices. Ireland is currently experiencing deflation which means the economy is shrinking in value instead of rising, this is due to the recession which hit our shores hard.

Causes of Inflation
Demand pull inflation Demand pull inflation occurs when the demand for products and services exceeds the amount available at existing prices. This excess demand pulls up prices as they are certain of getting the risen price for the good because the demand is so high. This type of inflation is most common in times of full employment eg Irelands housing boom in the years of the Celtic Tiger, the demand for property rise at a drastic amount which resulted in the prices of houses rising sky high as people wanted to get on the property ladder as soon as possible at fears of ever increasing house prices. Cost push inflation Cost push inflation occurs when the costs of production for the supplier rise without any corresponding increase in productivity and in turn the prices of their products also rise which increases inflation rates. This can be seen in many businesses throughout Ireland with rising oil prices for example means prices for their products must also rise to pay the extra oil charges however this does not result in more output being created.

Wage increases Wage increases also rise inflation rates. Increases in wages, especially those granted in excess of increases in productivity have the effect of increasing prices, eroding competitiveness and a worsening of the balance of payments. If employees must be paid higher wages it reduces the profit margin of the company, this can be seen in the many rises of the minimum wage over the years of the Celtic Tiger.

Increases in levels of VAT When the government increases the levels of VAT inflation will also suffer depending on an increase in VAT levels of a decrease. When VAT levels rise they are indirectly increasing the general level of prices to the final consumer. An example of this can be seen by the decision of the Irish government to rise VAT levels in the 2012 budget from 21% to 23%, an increase of 2%. Some businesses such as lidl have decided to take the increases on themselves and not transfer the extra costs to customers as an incentive so they will gain more trade for the business.

Increases in levels of indirect taxes The increases of taxes on goods such as petrol, cigarettes and drink. Such taxes are not normally imposed at the budget time. An increase on the price of petrol and diesel by 1.5c was made in the budget 2012 which increases travel costs for businesses and in turn their products prices must rise to combat the price increases.

Curbing Inflation
Curbing inflation is the theory behind how to counteract inflation rates, eg decreasing inflation rates, government action needed to save money like freezing public sector wages so they cannot get wage increases until the freeze is lifted when inflation rates rise again. Here are some of the methods used to curb inflation rates: Reducing consumption

To reduce public expenditure the government can adopt higher taxes, when taxes are risen the consumers in turn has less disposable income which means the demand for products fall and in turn the prices for said products also falls, this results in a decreasing inflation rate. Eg the budget 2012 tax increase of 2% results in a more drastically decreasing inflation rate at a time we strive to see rising inflation rates as it means the countries wealth is growing not just putting more fuel on the fire as seen by this government decision. Reducing investment The government should not be prompt to reduce investment levels as this would discourage investment which forms the basis of the future wealth creating capacity of the economy and kills employment creation. The government prefairs to tackle demand pull inflation by reducing consumption expenditure. Reducing government expenditure The government can reduce its expenditure by reducing the volume and the quality of public services. eg the cancellation of the luas expansion plan and no trainee gardai being taken on in Templemore.

Effects of Inflation
With rising prices in Ireland we are being more and more priced out of the European market. This decreases our exports which are a vital source of sales for Irish businesses. When inflation rates are decreasing normally the people which are dependant on social welfare fair out worst, this is due to low social welfare rates and rising taxes.

Construction of the CPI

To construct the CPI you must choose a base year and let the base year = 100. You must then calculate simple price index for each of the goods. Then you must then find the weight or percentage of income to spend on each good and multiply the simple price index for each good by % of income spent on that good and all the amounts in a given year.

Inflation Rates in Ireland since 2000

From 2000 and 2008 Ireland was still very much so still enjoying the Celtic tiger, with inflation rates extremely high from the property boom and then the collapse of the construction sector due to recession, inflation rates dived in 2008 as the country entered recession.

Effectiveness of CPI
Although the CPI gives a general understanding of spending patterns it does not give close enough detail to many areas. It shows an overstatement of the cost of living, when goods included in the index rise in price then other cheaper goods may be substituted in which case the CPI would overstate the cost of living for those people. It cannot be taken for granted that it is a cost of living index as it does not show detail of spending. It is constructed for the average citizen and not for people on high incomes or people on social welfare which can lead to the index not applying to some people.

Uses of CPI
Trade unions use the CPI as an indication of living standards which they use in negotiations for wage increases, this is the most important use for the CPI. The government uses it as a guideline when constructing the budget, they base social welfare payments on changes in the CPI.

Investors use the CPI for investment decisions. If there are low levels of inflation they will be willing to invest in Ireland.

We can compare our CPI with European countries to evaluate weather we are competitive for exports in their countries.

Financial institutions use the CPI to base their levels of interest which protects the customer from becoming a victim of the rising levels.

2 (c) Construct a CPI for the given figures

Base year = 2007 Construct a CPI for food, clothing, entertainment and other ITEM Food Clothing Entertainment Other YEAR 2007 100 100 100 100 2008 120 106.6 120 104.1 2009 160 133.3 130 140

Food Clothing Entertainment Other

36% 21% 12% 42%

48% 27% 13% 56%

Evaluation

By completing this assignment I now understand why inflation rates have such an effect on the economy, they reflect on the wealth which is circulating in a country. I also understand how to construct a consumer price index and why it is used when it is not in detail. Overall I am happy with the way the assignment flows and it shows every detail asked for by our brief.