Evaluation

Question 1

Problems with using the CPI to measure inflation

Answer 1

The basket of goods and services generated will not necessarily reflect the consumption habits of all consumers in the economy. Each consumer will not purchase every item in the basket and will not spend the same proportion of their income on items exactly as they have been weighed. High-income earners will spend money on luxury goods such as foreign holidays whereas for low income earners bus travel may be a majority purchase. Therefore, if foreign holidays shot up considerably and fed through to a higher inflation rate, this would not be felt by low income earners and thus the inflation rate rise wouldn’t be representative of low income earners.

Question 2

Costs of inflation

Answer 2

• Purchasing power falls as those who are on fixed incomes suffer a decrease in their real income so spending power falls, decreasing consumption in the economy and AD
• Reduced int’l competiveness as the demand for exports reduce and revenue generated from them. Imports become more competitive, increasing the demand for them, this worsens the current account reducing the value of (x-m) in AD and decreasing economic growth
• Fiscal drag as workers receive a pay increase that matches inflation buy pushed them into higher income tax band that is not adjusted to inflation. In real terms, the individual is not better off with this pay rise as they now have to pay a higher marginal rate of income tax making them worse off than before - this is unfair and can reduce the incentives for individuals to earn higher incomes