IB Economics 3.3.4 Low and Stable Rate of Inflation Notes

1. Price stability is a core macroeconomic goal because when prices barely move, people and firms can trust the value of money and plan ahead.
2. As this section shows, when prices stay relatively stable the whole economy works better:
   1. Consumers spend with confidence because they can predict what their money will buy next month, so they do not hoard or panic-buy.
   2. Businesses invest and plan effectively because stable prices make future costs and revenues predictable, lowering the risk of long-term projects.
   3. The economy runs more efficiently because resources flow to their best use instead of being wasted coping with rising or falling prices.

Measuring inflation using the consumer price index (CPI)

1. The CPI tracks inflation (and deflation) by pricing a fixed, weighted basket of goods and services bought by a typical household, so it captures the average price a real family faces.
2. Inflation is then the percentage change in that basket's value over time, so a rising CPI means prices are climbing and a falling CPI means they are dropping.

Calculating inflation

With the CPI known, the inflation rate is found as the percentage change in CPI from one period to the next, using this formula:

$$\text{Inflation Rate}=\frac{(100\text{Weighted Price Index}−100​)} \times 100$$

Table 1 above shows the CPI data for an imaginary economy, Econland. The inflation rate for each year is found by applying the formula above.

From Year 1 to Year 2:

• CPI in Year 2 = 105
• CPI in Year 1 = 100
• Inflation Rate: $\left( \frac{105 - 100}{100} \right) \times 100 = 5.00\%$

From Year 2 to Year 3:

• CPI in Year 3 = 110
• CPI in Year 2 = 105
• Inflation Rate: $\left( \frac{110 - 105}{105} \right) \times 100 = 4.76\%$

From Year 3 to Year 4:

• CPI in Year 4 = 120
• CPI in Year 3 = 110
• Inflation Rate: $\left( \frac{120 - 110}{110} \right) \times 100 = 9.09\%$

From Year 4 to Year 5:

• CPI in Year 5 = 125
• CPI in Year 4 = 120
• Inflation Rate: $\left( \frac{125 - 120}{120} \right) \times 100 = 4.17\%$

The limitations of the CPI in measuring inflation

Several limitations reduce the CPI's accuracy as a measure of inflation, because a fixed basket cannot fully track how people really shop. These include:

1. Substitution bias overstates inflation:
   1. When prices rise, consumers switch to cheaper alternatives, so their real cost of living rises less than the headline figure suggests.
   2. But the CPI uses fixed weights and keeps assuming people buy the same quantities, so it misses this switching.
   3. As a result the index overestimates the true increase in living costs.
2. Quality changes distort the figure:
   1. When goods get better, quality improvements are not fully separated out, so a price rise that reflects a better product still shows up in the data.
   2. So price increases caused by genuine quality improvements are wrongly counted as inflation, overstating it.
3. New products enter the basket too slowly:
   1. The CPI basket takes time to add new goods and services, so fast-changing spending is not captured promptly.
   2. This delay means important shifts in what households actually buy are not reflected quickly.
   3. So the index can become outdated in rapidly evolving markets, such as technology, where new products appear constantly.