Understanding Consumer Price Index

The assignment delves into the Consumer Price Index (CPI), a key measure of inflation. It outlines the advantages of CPI, including its comprehensiveness, measurability, consistency, and flexibility in adapting to various consumer preferences and economic situations. However, it also highlights the limitations of CPI, such as its inability to capture product quality improvements, fluctuations in consumer demand, and the impact of technological advancements on production costs.

Running Head: BUSINESS ECONOMICS
Business Economics
Name of the Student
Name of the University
Author note

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Table of Contents
Answer 9..........................................................................................................................................3
Answer a......................................................................................................................................3
Answer b......................................................................................................................................3
Answer c......................................................................................................................................3
Answer d......................................................................................................................................3
Answer e......................................................................................................................................4
Answer e......................................................................................................................................4
Answer g......................................................................................................................................5
Answer 11........................................................................................................................................6
Answer a......................................................................................................................................6
Answer b......................................................................................................................................8
Answer 12........................................................................................................................................8
Answer a......................................................................................................................................8
Answer b......................................................................................................................................9
Answer c....................................................................................................................................10
Answer 13......................................................................................................................................11
Answer a....................................................................................................................................11
Answer b....................................................................................................................................12
Answer c....................................................................................................................................13
Answer d....................................................................................................................................14
Answer 14......................................................................................................................................15
Answer a....................................................................................................................................15
Answer b....................................................................................................................................16
References......................................................................................................................................17

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Answer 9
Answer a
GDP = Consumption (C) + Investment (I) + Government Expenditure (G) + (Export (X) –
Import (Y))
= {$60 + $5 + $8 + ($7- $10)} billion
= ($60 + $5 + $8 - $3) $ billion
=$ 70 billion
Answer b
Injection = Investment + Government Expenditure + Export
= (5 + 8 +7) $ billion
= $ 20 billion
Answer c
Withdrawal = Saving + Tax + Import
Given no information on saving and Tax, there is only one source of leakages namely imports.
Therefore, withdrawal = Import = $10 billion
Answer d
Tax revenue = $ 7 billion
Saving = Tax revenue – government expenditure
= ($7 - $8) billion

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= -$1 billion
The negative amount represents dissaving.
Answer e
If GDP raises to $80 billion, then change in GDP = ($80 -$70) billion = $10 billion
Previously domestic consumption = Total consumption – import
= ($60 - $10) billion
= $50 billion
Now, consumption of domestically produced goods rises to $58 billion
Change in consumption = ($58 - $50) billion
= $8 billion
∆ Y = ΔC
1−MPC
¿ , 10= 8
1−MPC
¿ , 1−MPC=0 . 8
¿ , MPC=1−0 . 8
¿ , MPC=0 . 2
Answer e
Multiplier= 1
1−MPC

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¿ 1
1−0 . 2
¿ 1
0 .8
¿ 1 .25
Answer g
Initial level of GDP = $80 billion
Export rises by $4 billion
Investment rises by $1 billion
Government expenditure falls by $2 billion
Current GDP = ($80 + $4 + $1- $2) billion
= ($85 - $2) billion
= $83 billion
Therefore, GDP will rises by ($83 - $80) = $3 billion.

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Answer 11
Answer a
Demand-Pull and Cost-push inflation
Inflation captures gradual increase in the price level. There are both demand and supply
side factors that causes price level to rise. When price increases because of an increase in
aggregate demand then it is called demand-pull inflation while inflation resulting from an
increase in production cost is known as cost-push inflation (Mankiw, 2014).
Figure 1: Demand-Pull inflation
(Source: as created by Author)
There are different factors that cause an increase in aggregate demand. Change in any
exogenous factor causing an increase in demand shifts the aggregate demand curve to the right.
Figure 1 explains this. Suppose there is an increase in aggregate demand shifting the demand

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curve from AD to AD1. With given aggregate supply, this leads to an increase in price level from
P* to P1.
Figure 2: Cost-Push inflation
(Source: as created by Author)
Cost-push inflation resulted from an increase in production cost and raise price through
an inward shift of the supply curve. Suppose, in an economy there is a sudden increase in input
prices. As a result, there will be contraction of supply seen as a shift of the supply curve from AS
to AS1. With a contraction of supply, price will go up from P1to P2.

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Answer b
Causes of demand-pull inflation
Economic growth: In a growing economy, demand follows a general increasing trend. When
economy grows, then people’s income increases. People become more confident and willing to
spend more money on consumption. This raises demand in the economy and price increases.
Expansion of money supply: In times of expansionary monetary policy government increases
supply of money (Weale et al., 2015). This means people have more money to spend on goods.
This increases demand for goods and services and push-up price level.
Causes of cost-push inflation
Wage inflation: When wage increases, then firm have to pay a high wage to worker. This raises
production cost and hence supply contracts (Shapiro,2016). Because of supply shortage price
increases.
Natural disaster: In times of natural disaster, there is disruption in production and supply.
Because of natural disaster, there is depletion of natural resources. This limits supply of goods
and cause inflation.
Answer 12
Answer a
The policymakers in a nation target to achieve full employment. However, the term full
employment does not mean measured unemployment is zero. The zero unemployment is a myth
and is an unhealthy sign for the economy. Even a healthy economy has some amount of
unemployment. People always make transition between jobs causing frictional unemployment.

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When unemployment rate is zero or close to zero, then this means there is something odd with
dynamic movement of people between jobs. In order to eliminate frictional unemployment the
new jobs created should match the skills of those leaving jobs. The frictional unemployment
reflects flexibility of the workers to move between jobs. This is the reason macroeconomic
policy should not target zero unemployment. Instead, a low unemployment of less than 3% is
targeted for a healthy economy. The level of unemployment that an economy always has is
called natural rate of unemployment.
Answer b
The long-term classical model is built with downward sloping aggregate demand curve
and a vertical aggregate supply curve. In this mode, the equilibrium is determined only at the
level of full employment. If price is above the equilibrium price, then there is an excess supply
while below equilibrium there is an excess demand. Therefore, economy is always at full
employment level. Any unemployment according to classical economists is only temporary and
the autonomous adjustment process restores full employment (O'Brien, 2017). Unemployment in
the economy only indicates a disequilibrium phenomenon.

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Figure 3: Classical model in the long run
(Source: as created by Author)
Answer c
Structural unemployment is the type of unemployment caused from structural mismatch.
Structural unemployment occurs when people do not have skills required for specific jobs.
Unemployment arises because of a mismatch of skills and geographical location. Cyclical
unemployment is resulted from business cycle fluctuation. In times recession, people remain the
economy undergoes with a gradual downturn (Petrakis, Kostis& Kafka, 2014).This by pulling
down aggregate demand lead to contraction of economic activity. With lower job opportunities,
unemployment increases.

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Both cyclical and structural unemployment are cause of concern for policymakers.
Structural unemployment resulted from mismatch between workers’ skill and available jobs
leads to long term unemployment and raises the natural rate of unemployment. For structural
unemployment, unemployed workers of one industry should be absorbed by some other sectors
of the economy. Here, policymakers or government has very little scope of intervention.
However, cyclical unemployment resulted from declining demand during recession can be
reduced by taking expansionary policy to stimulate aggregate demand in the economy.
Answer 13
Answer a
Figure 4: Effect of improvement in marketing and selling skill
(Source: as created by Author)

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The balance between aggregate demand and aggregate supply determines the
macroeconomic equilibrium in an economy. Corresponding to the equilibrium price and income
levels are determined (Agénor&Montiel, 2015).An improvement of marketing and management
skill will increase the supply of skilled labor force. This in turn increases aggregate supply
shifting the AS curve to the right. As the aggregate supply curve shifts, the economic equilibrium
shifts from E1 to E2. Accordingly, in the new equilibrium price level declines while GDP
increases.
Answer b
Figure 5: Effect of an increase in personal income tax
(Source: as created by Author)

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An increase in personal income tax will reduce disposable income of the household. The
household now have less income to spend on goods and services. As consumption expenditure
decreases, the aggregate demand decreases as well. This is shown from the leftward shift of
supply curve from AD to AD1. At new equilibrium E1, both GDP and price decreases.
Answer c
Figure 6: effect of an increase in export
(Source: as created by Author)
Net export is an important component of aggregate demand. With increase in export
earnings from export increases as well. Given import, this increases net export and shift the
demand curve outward from AD1 to AD2. The equilibrium shifts from E1 to E2. At E2, there is an
increases in both GDP and price level.

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Answer d
Figure 7: effect of destruction of capital stock
(Source: as created by Author)
After destruction of capital stocks, suppliers in the economy left with less amount of
capital. Capital being one of the major inputs of production, a decrease in capital supply hampers
production. The supply curve shifts inward from AS to AS1. With shift of the supply curve price
level increases owing to a supply shortage. The level of economic activity decreases as reflected
from a decline in GDP.
Answer 14
Answer a
Advantages of Consumer price index

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Large categories: CPI includes a large basket of goods that make it a legit indicator of inflation.
CPI includes category like food, beverages, transportation, housing and meditation.
Measurable: As CPI includes only quantifiable objects, it becomes easier to compare price and
level of inflation.
Consistency and flexibility: Two-core strength of CPI is consistency and flexibility. CPI
measures the costs of a certain basket of good, which remain consistent representing the average
cost that consumers face to maintain an average standard of living (Fallis, 2014).The flexibility
of CPI is reflected in various versions of CPI that take into account external factors like seasonal
adjustment and choice of consumers.
Limitation of Consumer Price Index
Quality of product: CPI measures cost of living and an increase in CPI implies increase in price
or inflation. However, it might also be the case that price of the good increase due to an
improvement of quality. CPI does not include qualitative aspect.
Fluctuation: During price fluctuation, people changes their preference of goods and services.
This is not considered while computing CPI. CPI continues to take the old basket of goods.
Overestimation of inflation: CPI does not take into consideration technological improvement in
production of goods.
Answer b
Inflation that captures variability of price level leads to a change in income distribution of
the society. Some people gain while some loses for same level of price increase. The poorer
section of the society likely to be suffers from inflation, as they are unable to protect themselves

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against increasing prices. People in the fixed income groups lose. There are four categories of
people suffering from loss in real income. These are salaried people, government bondholders,
renter class and pensioners. The gain or lose to wage earners depend on their terms of job
contracts and ability to obtain an increase in payment. On the other hand, professional and
business people gain from inflation. As price rises faster than cost, profit increases (Schneider,
2014). Inflation causes a redistribution of income from the fixed income people to those earning
variable income. Savers are also penalized from inflation as real return from saving decreases
during inflation. Lenders are benefitted during inflation at the cost of borrowers.

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References
Agénor, P. R., &Montiel, P. J. (2015). Development Macroeconomics Fourth edition. Economics
Books.
Fallis, G. (2014). Consumer Price Index. Encyclopedia of Quality of Life and Well-Being
Research, 1217-1218.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.
O'Brien, D. P. (2017). The classical economists revisited. Princeton University Press.
Petrakis, P. E., Kostis, P. C., & Kafka, K. I. (2014). Structural and Cyclical Unemployment.
In The Rebirth of the Greek Labor Market (pp. 39-48). Palgrave Macmillan, New York.
Schneider, M. (2014). Redistribution effects of inflation. Journal of Economic Dynamics and
Control, 49, 49-51.
Shapiro, M. D. (2016). Supply shocks in macroeconomics (pp. 1-7). Palgrave Macmillan UK.
Weale, M., Blake, A., Christodoulakis, N., Meade, J. E., & Vines, D. (2015). Macroeconomic
policy: inflation, wealth and the exchange rate (Vol. 8). Routledge.