Economic Growth, Unemployment and Inflation: Question 3

Worked solution

Part (a): Building the weighted CPI and finding the inflation rate

Each category’s Year 2 price index is weighted by its importance in the basket, then the weighted values are summed and divided by the total weight:

$\text{CPI}_{\text{Year 2}} = \frac{(40\times106) + (35\times104) + (25\times112)}{40+35+25}$

$= \frac{4240 + 3640 + 2800}{100} = \frac{10680}{100} = 106.8$

The rate of inflation is the percentage change in the CPI from the base year (Year 1 $=100$):

$\text{Inflation rate} = \frac{106.8-100}{100}\times100 = 6.8\%$

So Astrella’s overall CPI for Year 2 is $106.8$, giving a rate of inflation of $6.8\%$.

Part (b): The real value of the wage

The real value of a nominal amount is found by dividing by the price index and multiplying by 100, using the CPI found in part (a):

$\text{Real wage}_{\text{Year 2}} = \frac{3100}{106.8}\times100 \approx 2902.62$

In Year 1, the worker’s real wage was simply $3,000 (Year 1 is the base year, so nominal and real values are equal). In Year 2, this same wage is worth only about $2,902.62 measured in Year 1 prices. Since $2902.62 < 3000$, the worker is worse off in real terms: although the nominal wage rose by $\frac{3100-3000}{3000}\times100 \approx 3.33\%$, this was smaller than the $6.8\%$ rate of inflation, so prices rose faster than the wage, eroding its purchasing power.

Part (c): Demand-pull or cost-push?

Demand-pull inflation is caused by aggregate demand rising faster than aggregate supply, while cost-push inflation is caused by rising costs of production shifting aggregate supply to the left.

The stem states that consumer spending and household borrowing (both components/drivers of aggregate demand) were unchanged over the period, so a rise in aggregate demand cannot explain the price rises. Instead, the price rises were driven by a sharp increase in the world price of imported crude oil, which raised firms’ fuel and transport costs across the economy, consistent with the largest individual price rise being in the transport category ($100\to112$) and a substantial rise in housing and fuel ($100\to104$), both heavily exposed to oil costs. This is a rise in the cost of a key input, which is the defining feature of cost-push inflation, not demand-pull inflation.

Part (d): Inflation, disinflation or deflation?

The neighbouring economy’s rate of inflation is:

$\frac{105-108}{108}\times100 \approx -2.78\%$

Because this rate is negative, the general price level is not just rising more slowly than before (it is actually falling. This is deflation: a sustained fall in the general price level, shown here by the CPI itself falling from 108 to 105. This is different from disinflation, which describes a slowdown in the rate of inflation while prices are still rising overall (a positive but falling inflation rate)) that is not what is happening in this neighbouring economy, since its price index has fallen in absolute terms.

Final answers

• (a) CPI (Year 2) $=$ $106.8$; rate of inflation $=$ $6.8\%$
• (b) Real wage (Year 2, in Year 1 prices) $\approx$ $2,902.62. The worker is worse off in real terms
• (c) Cost-push inflation, driven by higher imported oil costs raising firms’ costs of production, with aggregate demand unchanged
• (d) Rate of inflation $\approx$ $-2.78\%$. This is deflation (a falling price level), not disinflation