Monetary Policy

• Inflation refers to an increase in the general level of prices. It reduces the Purchasing power of money.

  Inflation in Ireland is measured by the CSO.
• The Consumer Price Index (CPI)

  The CPI measures inflation as follows:

  • A basket of Goods and Services are priced each month.
  • Weights are applied to spending on each category of item.

  These weights give more importance to some price increases compared to others.

  The weights represent the percent of income the average consumer spends on a particular good/service.
• Uses of CPI

  • measures inflation and is an indicator of the performance of an economy. e.g. high inflation rate indicates the economy is growing too rapidly and is overheating.
  • Policymakers can use CPI when making decisions - e.g. if inflation is high the govt can lower spending in the budget or increase labour taxes
  • used when making international comparisons e.g. price of bread in Ireland may be higher than in spain due to higher inflation here
  • used by workers and their unions to justify pay rises and used when the government needs to adjust social welfare payments.
• Limitations of the CPI

  • It is based on an average pattern of spending. Your households spending patterns could be very different from the 'average' households.
  • Rural vs Urban - The CPI does not distinguish between urban and rural dwellers. The cost of living can rise faster in urban areas than in rural areas. e.g. rent increases urban areas are higher than in rural
• HICP - Harmonised Index of Consumer Prices

  is calculated in each EU member state using the same methodology in each state so that comparisons can easily be made between EU members. The CSO calculates this for Ireland but it is not the same as CPI as some items are not included in it that are included in Ireland e.g. Ireland has demand for chicken fillet roles while other countries don't.
• MUICP - Monetary Union Index of Consumer Prices

  This measures inflation in the 20 eurozone countries only. It is a weighted average of HICP in the 20 eurozone countries only
• Calculating Composite Price Index

  • Choose a representative base year
  • Decide what goods to include in the composite price Index
  • Gather Data: find the price of each good for each time period being observed
  • Construct Simple price Index by dividing price of item in current year by price of item in base year, then multiply by 100
  • Get the 'weight' of each good, which is the percentage of income the average consumer spends on the item.
  • Add up all the price changes to get overall price change, this is the price index of the current year
  • to get inflation rate, (price index - 100)
• nominal wage - is the wage before it has been adjusted for inflation

  Real wage - is the money wage after it has been adjusted for inflation. It relates to the purchasing power of the nominal wage

  Percentage change in the Real wage - (percentage change in nominal wage - the inflation rate)
• Economic Effects of Inflation

  1. Inflation Reduces the Purchasing power of money
  2. Those on Fixed Incomes suffer a reduction in their standard of living
  3. Inflation reduces the purchasing power of savings
  4. The Burden of Debt repayments are reduced by Inflation
  5. Investment Falls when Inflation is High
  6. Inflation Reduces the Competitiveness of Exports
• 1 Inflation Reduces the Purchasing Power of Money

  It now requires an increased amount of money to purchase the same amount of goods/services. This means that the purchasing power of the consumer has fallen, meaning they can purchase fewer goods than they were previously able to, resulting in a lower standard of living.
• 2. Those on Fixed Incomes suffer a reduction in their standard of living

  People who earn fixed allowances e.g.those on social welfare, suffer the most due to high inflation, as these types of payments can only increase once per year. e.g. in the budget. A rise in the general level of prices reduces their standard of living.
• Loss of International competitiveness

  If a country is experiencing high inflation, it means that it is losing international competitiveness. The rising cost of production due to inflation is passed onto goods/services (cost-push inflation). This makes Irish goods/services less attractive in foreign markets affecting our exports. It may also mean domestic consumers are more likely to buy cheaper imports negatively affecting the balance of payments.
• Investment falls when Inflation is High

  During times of inflation Costs of Production e.g. Raw Materials, rent, labour will increase. It is then difficult for new firms to starts up, or for existing firms to invest/expand due to an uncertainty regarding future costs of production. Employees also are likely to demand pay rises at a time of high inflation which deters firms from investing and recruiting.
• Causes of Inflation

  Inflation - caused by an increase in the supply of money

  1. Rising Income
  2. Indirect Taxes
  3. Higher Costs of Production
  4. Currency Depreciation
  5. Printing Money
• Cost-push Inflation - occurs when the cost of production is passed onto consumers in the form of higher prices. E.g. cost of raw materials

  Demand-pull Inflation - occurs when the total/aggregate demand for goods/services is greater than the total/aggregate supply of goods/services. There is excess demand, which pulls up the price level.
• Deflation - is the fall in the general level of prices
• Effects of Deflation

  • Consumer spending falls - if prices continuously fall, consumers defer their spending waiting for prices to drop further. This causes a short-term loss in economic growth as less money is flowing in the economy.
  • Investment falls - due to a period of uncertainty. Suppliers would potentially be required to lower future prices of their goods/services due to law of supply, makes investment less appealing
• Effects of Deflation

  • Employment falls - during periods of deflation, firms make less profits as they must reduce prices to encourage consumer spending. Therefore, firms must lower their costs by recruiting less people and potentially making redundancies.
  • Government Budget Difficulties - Rising unemployment caused by the aggregate fall in demand results in increased social welfare costs. There is also reduction in revenue from labour taxes and in indirect taxes e.g. VAT due to less consumer spending
• How can the monetary policy be used if there is deflation?

  Adjusting Interest Rates

  • The ECB can reduce the Key Interest Rate
  • Cost of credit falls
  • borrowing rises
  • saving falls
  • spending and investment in the economy rises

  Adjusting Money Supply

  • The ECB can engage in quantitative easing
  • New money supply would rise
  • Banks have access to new money
  • Banks lend this to customers
  • Demand for goods/services rise

  Adjusting Credit Availability

  • ECB could lower the minimum reserve requirements of banks
  • increasing ability to create credit
• Role of the ECB

  • ensures price stability - It maintains the purchasing power of the euro. It aims for an inflation rate of 2% over the medium term.
  • formulates the monetary policy - in conjunction with other central banks in the eurozone
  • sets interest rates - It increases the interest rate to reduce inflation and decreases then to increase/stimulate economic growth. This is done by adjusting key interest rates.
  • manages external foreign currency reserves of the eurozone - it buys and sells foreign currencies to influence the price of euro in terms of other currencies.
• Implications of the Irish economy for being a member of the EU

  • Membership of the eurozone encourages international trade - as a small open economy, dependent on international trade, Ireland benefits from the Eurozone. The elimination of exchange rate risks and transaction costs reduces the costs of engaging in international trade.
  • Monetary policy may be unsuitable - as the monetary policy is set to apply to the eurozone as a whole, the policy may not suit the Irish economy. E.g. celtic tiger
  • Loss of economic control - Ireland has lost its sovereignty over the monetary policy.