Module 8 - Inflatie.docx

# Understanding the consumer price index The consumer price index (CPI) is a crucial economic indicator used to measure the evolution of prices for a basket of goods and services, thereby quantifying inflation. ### 1.1 Definition and purpose of the CPI The CPI, also known as the index of consumer prices, is a monthly compilation of prices for goods and services, prepared by the Belgian Federal Public Service for Economy. It serves as a key conjunctural indicator, informing governmental and economic decision-making. The composition of the index is derived from household budget surveys, conducted every two years. The primary function of the CPI is to objectively reflect the price evolution over time for a representative basket of goods and services purchased by households, reflecting their consumption patterns. It measures the fluctuation of this price level between periods, using an initial period as a base for comparison, and expresses this change in relative terms. To be an effective measurement tool, the CPI must meet several conditions: * **Representativeness:** The basket of goods and services included in the CPI must be representative of the general price level of all goods and services. This means it should include products that align with typical consumer purchasing behavior, informed by surveys. * **Flexibility:** As consumption habits change and new products emerge, the basket needs regular adjustments. Some products may be removed, while new ones are added to maintain relevance. * **Weighting:** Not all products hold equal importance for consumers. To accurately reflect the significance of different products, weighting coefficients (or weights) are applied. Products that are more important to consumers are given a higher weight. The current CPI, with a reference year of 2013 set at 100, began in January 2014. It is a chain index, updated annually in January. These annual updates ensure the CPI remains representative over time, preventing distortions in measured inflation as the index ages. The basket contains over 600 products. For instance, in 2020, eight new products (non-alcoholic beers, shower heads, table runners, denture cleaners, tire storage and replacement for summer and winter tires, pet boarding services, umbrellas, and sunglasses) were added, while two were removed (sunbed subscriptions and cordless landline phones). ### 1.2 Calculation of the CPI The calculation of the CPI can be illustrated with a hypothetical example. #### 1.2.1 Simple price index The first step involves calculating the simple price index for each individual product. Using 2014 as the base year, the prices in that period are set to 100. For example, if the price of a pizza was 7.50 dollars in 2014 and 13.33 dollars in 2016, the simple price index for pizza in 2016 would be: $$ I_p = \left( \frac{P_t}{P_0} \right) \times 100 $$ Where: * $I_p$ is the simple price index. * $P_t$ is the price at time $t$. * $P_0$ is the price at the base period. Using the example data: * For pizza (2016): $I_p = \left( \frac{8.5}{7.5} \right) \times 100 \approx 113.33$ * For beer (2016): $I_p = \left( \frac{1.75}{1.5} \right) \times 100 \approx 116.67$ This indicates that by 2016, the price of a pizza had risen by approximately 13.33% compared to the base year, and the price of a pint of beer had risen by approximately 16.67%. #### 1.2.2 Synthesized or composite index To summarize the price evolution of multiple products into a single figure, a synthesized or composite index is calculated. This is typically done by taking the arithmetic mean of the simple price indices. * **Unweighted Composite Index:** If we consider the average price change for pizza and beer: * Average for 2016: $\frac{113.33 + 116.67}{2} = 115$ * Average for 2017: $\frac{9.75}{7.5} \times 100 = 130$ (for pizza) and $\frac{2.25}{1.5} \times 100 = 150$ (for beer). * Average for 2017: $\frac{130 + 150}{2} = 140$ This implies that, on average, the prices of these two products increased by 15% in 2016 and 40% in 2017 compared to the base year. * **Weighted Composite Index:** To account for the different importance of products, weights are applied. For instance, if pizza has a weight of 1.4% and beer has a weight of 0.95%: $$ \text{Weighted Composite Index} = \frac{\sum (w \times I_p)}{\sum w} $$ Where $w$ is the weight of each product. Using the example data: * For 2016: $$ \text{Weighted Index} = \frac{(1.4 \times 113.33) + (0.95 \times 116.67)}{1.4 + 0.95} \approx \frac{158.662 + 110.8365}{2.35} \approx 114.68 $$ * For 2017: $$ \text{Weighted Index} = \frac{(1.4 \times 130) + (0.95 \times 150)}{1.4 + 0.95} = \frac{182 + 142.5}{2.35} = \frac{324.5}{2.35} \approx 138.09 $$ This indicates that family expenses for these two products increased by approximately 14.68% in 2016 and 20.41% in 2017 relative to the base period. > **Tip:** When dealing with multiple years and base years, always ensure you are using the correct base prices ($P_0$) for your calculations. ### 1.3 Importance of the CPI The CPI is fundamental in Belgium for determining inflation. Beyond the general CPI, there is also the health index, introduced in 1994. The health index uses the same basket of goods but excludes certain items like gasoline, alcohol, and tobacco. This health index is specifically used in Belgium for wage indexation. #### 1.3.1 Wage indexation Wage indexation is linked to the rolling four-month average of the health index. When this average crosses a predefined threshold, known as the "spilindex" (which is 2% higher than the previous threshold), pensions and benefits automatically increase by two percent one month later. Civil servant salaries are adjusted a month after that. This system aims to maintain purchasing power. Wages in the private sector are subject to agreements made within specific sectors. ### 1.4 The phenomenon of inflation Inflation is defined as a persistent general increase in the prices of consumer goods. As noted, the CPI is used to calculate inflation. A continuously rising CPI means that people can purchase fewer goods and services with their income, leading to a decrease in their purchasing power. The inflation rate is calculated as follows: $$ \text{Inflation (\%)} = \left( \frac{\text{CPI}_{\text{year } x} - \text{CPI}_{\text{year } (x-1)}}{\text{CPI}_{\text{year } (x-1)}} \right) \times 100 $$ The opposite of inflation is deflation, which is a general decrease in the price level. While goods and services become cheaper during deflation, it can be detrimental to the economy. Consumers may postpone purchases, and businesses may delay investments in anticipation of further price drops. This can lead to unsold goods, reduced demand for raw materials, and increased unemployment. #### 1.4.1 Causes of inflation There are three primary causes of inflation: * **Cost-push inflation (supply-side inflation or structural inflation):** This occurs when businesses pass on their increased costs to consumers in their selling prices to maintain profit margins. For example, if the cost of producing an item rises, companies will often increase the selling price to preserve profitability. A common real-world example is rising gasoline prices when crude oil prices increase, or when labor costs per unit of production rise faster than average labor productivity. If price compensation is sought for this type of inflation, it can lead to a wage-price spiral. * **Demand-pull inflation (demand inflation or cyclical inflation):** Prices rise when the demand for goods and services exceeds the production capacity of the economy. This type of inflation is common during periods of strong economic growth (high conjunctures). Businesses, seeing high demand and profits, tend to raise prices. * **Monetary inflation:** This explanation, rooted in the quantity theory of money, attributes inflation to an excessive increase in the money supply. According to Fisher's equation of exchange, the flow of money and goods must be balanced. If the money supply increases, the flow of goods should also rise. If production capacity is fully utilized, the only way to accommodate a larger money supply is through price increases. #### 1.4.2 Consequences of inflation While a low inflation rate of around two percent per year is generally considered acceptable, higher inflation can have significant consequences: * **Impact on borrowers and lenders:** Debtors benefit as they repay loans with money that has less purchasing power than when they borrowed it. Conversely, creditors lose purchasing power on the money they receive back. * **Erosion of purchasing power of assets:** Financial assets with a fixed nominal value, such as bonds, lose purchasing power. * **Reduced purchasing power for those with stagnant wages:** Individuals whose wages do not keep pace with inflation will see their purchasing power decline. In Belgium, a system of "na-indexering" (delayed indexation) means wages are only adjusted after a certain period, exacerbating this effect. * **International competitiveness:** If a country's inflation rate is higher than that of its trading partners, its exports become more expensive, leading to decreased exports and increased imports. * **Substitution of labor by capital:** When wage increases outpace productivity gains, making labor relatively more expensive than capital, businesses may substitute labor with capital. This can lead to structural unemployment. > **Tip:** Understanding the distinction between nominal and real values is crucial when analyzing inflation's effects. Real values adjust for inflation, providing a clearer picture of purchasing power and economic growth. ### 1.5 Combating inflation Maintaining low inflation is a key objective for monetary authorities, such as the European Central Bank (ECB) in Europe. The methods used to combat inflation depend on its cause: * **For supply-side inflation:** Policies can include incomes and price controls. Income policies, such as wage moderation (e.g., prohibiting wage increases above a certain percentage), are a primary tool. Governments may also block prices, either completely or selectively. * **For demand-pull inflation:** This is typically addressed through restrictive monetary and fiscal policies. The money supply can be tightened by increasing benchmark interest rates. Governments can also curb demand by introducing additional taxes or reducing public spending and transfers. --- # The phenomenon of inflation Inflation is defined as a persistent rise in the general price level of consumer goods. ### 2.1 The consumer price index (CPI) The Consumer Price Index (CPI), also known as the index, is a monthly compilation of prices for goods and services, prepared by the Belgian Federal Public Service for Economy. It serves as an economic indicator used by the government and other economic actors for decision-making. #### 2.1.1 What is the CPI? The CPI reflects the price evolution over time of a basket of goods and services purchased by households, considered representative of their consumption habits. It measures the fluctuation of this price level between two periods, with the earlier period serving as the basis for comparison. This change is expressed in relative, not absolute, terms. For the CPI to function effectively as a measurement tool, it must meet several conditions: * **Representative:** The basket of goods and services must accurately reflect the general price level of all consumer goods and services, aligning with consumer purchasing behavior. This is determined through surveys. * **Flexible:** The basket needs regular updates to accommodate changes in consumption patterns and the introduction of new products. Some items are removed, while others are added. * **Weighted:** Different products have varying importance for consumers. Weighting coefficients (or weights) are assigned to reflect the significance of each product, with more important items carrying a higher weight. The current CPI in Belgium uses 2013 as the reference year, with the index set to 100. It is a chained index, updated annually in January, ensuring its representativeness over time and preventing measurement distortions as the index ages. The basket contains over 600 products, with additions and deletions occurring periodically to maintain relevance. #### 2.1.2 Calculating the CPI The calculation involves two main steps: 1. **Simple price index (enkelvoudig prijsindexcijfer):** This measures the price change of an individual product relative to a base year. The formula is: $$I_p = \frac{P_t}{P_0} \times 100$$ where $P_t$ is the price at time $t$ and $P_0$ is the price in the base year. 2. **Weighted composite index (gewogen samengesteld indexcijfer):** This combines the simple price indices of various products, taking into account their relative importance (weights). The formula is: $$\text{Weighted composite index} = \frac{\sum (w \times I_p)}{\sum w}$$ where $w$ is the weight of each product and $I_p$ is its simple price index. > **Tip:** The weighted composite index provides a more accurate picture of overall price changes by accounting for the varying impact of different goods and services on household budgets. #### 2.1.3 The health index In addition to the CPI, Belgium also uses a health index. This index is based on the same basket of goods but excludes certain items such as gasoline, alcohol, tobacco, and diesel. The health index is primarily used for wage indexation. #### 2.1.4 Wage indexation Wage indexation in Belgium is linked to the four-monthly moving average of the health index. If this average crosses a certain threshold (the "spilindex," which is 2% higher than the previous one), pensions and benefits automatically increase by two percent a month later, followed by civil servant salaries a month after that. This mechanism aims to preserve purchasing power. Private sector wage indexation depends on agreements within specific sectors. ### 2.2 The inflation phenomenon Inflation is characterized by a general increase in the prices of consumer goods, measured using the CPI. A rising CPI signifies that people can purchase less with the same amount of income, leading to a decrease in their purchasing power. #### 2.2.1 Calculating inflation The inflation rate is calculated as the percentage change in the CPI between two periods: $$\text{Inflation (\%)} = \frac{\text{CPI of current year} - \text{CPI of previous year}}{\text{CPI of previous year}} \times 100$$ > **Tip:** A positive inflation rate indicates prices are rising, while a negative rate signifies deflation. #### 2.2.2 Deflation Deflation is the opposite of inflation, representing a sustained decrease in the general price level. While seemingly beneficial, deflation can be detrimental to the economy. Consumers may postpone purchases in anticipation of further price drops, and businesses may delay investments. This can lead to reduced demand for raw materials and increased unemployment. #### 2.2.3 Causes of inflation Inflation can arise from several sources: * **Cost-push inflation (kosteninflatie):** This occurs when the costs of production increase, and businesses pass these higher costs onto consumers through increased prices to maintain profit margins. Examples include rising oil prices or higher labor costs per unit of output. If wage increases outpace productivity gains, this can lead to a wage-price spiral. > **Example:** If the cost of producing a product rises from 10 dollars to 12 dollars, a company that previously sold it for 15 dollars (making a 5 dollar profit) might raise the price to 17 dollars to maintain a 5 dollar profit. * **Demand-pull inflation (bestedingsinflatie):** This happens when the demand for goods and services exceeds the economy's production capacity. During periods of strong economic growth (hoogconjunctuur), businesses may raise prices to capitalize on high consumer demand and maximize profits. > **Example:** In a booming economy where consumers are eager to buy, businesses can charge higher prices for their products because demand is robust. * **Monetary inflation (monetaire inflatie):** This theory, based on the quantity theory of money, attributes inflation to an excessive increase in the money supply. According to the exchange equation of Fisher, the money supply multiplied by the velocity of money should equal the price level multiplied by the quantity of goods and services. If the money supply grows faster than the real output of goods and services, prices must rise to maintain equilibrium. #### 2.2.4 Consequences of inflation A moderate inflation rate, around 2 percent annually, is generally considered acceptable. It can encourage consumers to buy goods rather than delay purchases, and it makes borrowing more attractive as inflation erodes the real value of interest payments. However, high inflation can have several negative consequences: * **Redistribution of wealth:** Creditors lose out as they are repaid in money that is worth less in real terms, while debtors benefit. * **Decline in purchasing power:** The real value of financial assets with a fixed nominal value, such as bonds, decreases. Individuals whose wages are not fully indexed to inflation will experience a drop in their purchasing power. * **Impact on international competitiveness:** If a country's inflation rate is higher than that of its trading partners, its exports become more expensive, leading to decreased exports and increased imports. * **Structural unemployment:** If wage increases surpass productivity gains, making labor relatively more expensive than capital, businesses may substitute capital for labor, potentially leading to structural unemployment. #### 2.2.5 Combating inflation Maintaining low inflation is a primary objective for institutions managing monetary policy, such as the European Central Bank (ECB) in Europe. The strategies to combat inflation depend on its cause: * **Cost-push inflation:** Can be addressed through income and price policies, including wage controls (e.g., limiting wage increases above a certain percentage) and price freezes (either partial or total). * **Demand-pull inflation:** Is typically combated with restrictive monetary and fiscal policies. This can involve increasing key refinancing rates to limit the money supply or implementing higher taxes and reducing government spending or transfers to curb demand. ### 2.3 Contrasting inflation and deflation While inflation signifies a rise in general prices, deflation represents a fall in general prices. Both phenomena have significant economic implications. * **Inflation:** Encourages spending and borrowing, but high inflation erodes purchasing power and can harm international competitiveness. * **Deflation:** Can lead to postponed consumption and investment, reduced demand, and potentially higher unemployment. A stable price level, or low and predictable inflation, is generally considered the most conducive environment for sustained economic growth. --- # Causes and consequences of inflation Inflation is defined as a persistent, general increase in the price level of consumer goods. ### 3.1 Understanding inflation Inflation is measured using the consumer price index (CPI), which tracks the prices of a basket of goods and services representative of household consumption. This index is constructed to be representative, flexible, and weighted to reflect the importance of different products in consumer spending. The CPI is a chained index, updated annually, to ensure its continued relevance and prevent distortion of measured inflation over time. ### 3.2 Causes of inflation Three primary causes of inflation are identified: cost-push, demand-pull, and monetary inflation. #### 3.2.1 Cost-push inflation Cost-push inflation, also known as supply-push or structural inflation, occurs when businesses pass on increased production costs to consumers to maintain profitability. * **Mechanism:** If the cost of producing a good rises, companies will attempt to increase their selling price to preserve their profit margin. * **Example:** A rise in gasoline prices due to increasing oil costs or higher labor costs per unit of production. * **Wage-price spiral:** If demands for price compensation for increased labor costs outpace productivity gains, a wage-price spiral can emerge, where rising wages lead to higher prices, which in turn lead to demands for higher wages. This can be exacerbated by the timing of wage indexation relative to price increases. #### 3.2.2 Demand-pull inflation Demand-pull inflation, also known as demand-pull or cyclical inflation, arises when aggregate demand for goods and services exceeds the economy's production capacity. * **Mechanism:** This typically occurs during periods of strong economic growth (high conjuncture). Businesses, facing high customer demand, raise prices to maximize profits. * **Impact:** High demand leads to increased sales and, with constant costs, higher profits. #### 3.2.3 Monetary inflation Monetary inflation is explained by the quantity theory of money, attributing inflation to excessive growth in the money supply. * **Mechanism:** According to Fisher's equation of exchange, the money supply must be proportional to the flow of goods and services. If the money supply increases without a corresponding increase in the production of goods and services, prices are forced to rise. * **Equation of Exchange:** The relationship is often expressed as: $$M \times V = P \times T$$ Where: * $M$ = Money supply * $V$ = Velocity of money (the rate at which money changes hands) * $P$ = General price level * $T$ = Volume of transactions (or real output) * **Implication:** If $V$ and $T$ are relatively stable or cannot increase proportionally to $M$, then an increase in $M$ directly leads to an increase in $P$. ### 3.3 Consequences of inflation While a low inflation rate, around two percent annually, is considered acceptable and can encourage spending and borrowing, high inflation can have significant negative consequences. * **Reduces purchasing power:** For individuals whose incomes do not rise at the same rate as inflation, their ability to purchase goods and services decreases. * **Favors debtors over creditors:** Debtors repay loans with money that is worth less in real terms than when they borrowed it. Creditors, conversely, receive less in real terms than they lent. * **Erodes the value of financial assets:** Assets with fixed nominal values, such as bonds, lose purchasing power. * **Impact on international competitiveness:** If a country's inflation rate is higher than its trading partners, its exports become more expensive, and imports become relatively cheaper, leading to a decrease in exports and an increase in imports. * **Substitution of labor for capital:** If wage increases outpace productivity gains, making labor relatively more expensive than capital, businesses may substitute capital for labor, leading to structural unemployment. > **Tip:** A key distinction to remember is between nominal and real values. Inflation erodes the real value of money. For example, if inflation is 5 percent, then a sum of money today can buy 5 percent more than it can next year. * **Impact on GDP:** When an economy faces inflation, the nominal Gross Domestic Product (GDP) will grow faster than the real GDP, as nominal GDP includes the effect of price increases, while real GDP is adjusted for inflation. > **Example:** If nominal GDP grows by 7 percent and real GDP grows by 3 percent, the inflation rate is approximately 4 percent ($7\% - 3\% = 4\%$). ### 3.4 Combating inflation Managing inflation is a core objective of monetary policy, typically undertaken by central banks like the European Central Bank (ECB) in Europe. The strategies employed depend on the root cause of inflation. * **Combating cost-push inflation:** * **Income and price policies:** This can include wage moderation policies, such as limiting wage increases to a certain percentage. * **Price controls:** Governments can implement full or selective price freezes. * **Combating demand-pull inflation:** * **Restrictive monetary policy:** This involves increasing interest rates (e.g., the base refinancing rate) to reduce borrowing and spending. * **Fiscal policy:** Governments can increase taxes to reduce disposable income and aggregate demand, or reduce government spending and transfers. --- # Combating inflation Combating inflation involves implementing various strategies and policies by institutions like the European Central Bank (ECB) to control and manage rising price levels, addressing their underlying causes. ### 4.1 The role of the consumer price index in managing inflation The Consumer Price Index (CPI), or index of consumer prices, is a crucial economic indicator used to measure inflation. It tracks the price evolution of a basket of goods and services considered representative of household consumption patterns. #### 4.1.1 What the CPI measures The CPI is compiled monthly by statistical agencies and serves as a basis for decision-making by governments and economic actors. Key characteristics of the CPI include: * **Representativeness:** The basket of goods and services must reflect actual consumer purchasing behavior, determined through household budget surveys. * **Flexibility:** The basket is regularly updated to incorporate new products and adapt to changing consumption habits, ensuring the index remains relevant over time. * **Weighting:** Products are assigned weights (wegingscoëfficiënten) reflecting their relative importance in household expenditure. More important items have higher weights. The CPI is typically a chain index, updated annually, with a designated reference year set to 100. For instance, the CPI with a reference year of 2013 started at 100 in January 2014. The basket can contain hundreds of products, with additions and deletions occurring to maintain its representativeness. #### 4.1.2 Calculating the CPI The calculation involves two main steps: 1. **Simple Price Index (Enkelvoudig prijsindexcijfer):** This measures the price change of an individual product relative to a base year. The formula is: $$I_p = \frac{P_t}{P_0} \times 100$$ Where: * $P_t$ is the price at time $t$. * $P_0$ is the price in the base year. 2. **Weighted Composite Price Index (Gewogen samengesteld indexcijfer):** This combines the simple price indices of various products, taking into account their respective weights. The formula is: $$\text{Gewogen samengesteld indexcijfer} = \frac{\sum (g \times I_p)}{\sum g}$$ Where: * $g$ represents the weight of a product. * $I_p$ is the simple price index for that product. This weighted index provides a single figure representing the average price evolution of the entire basket of goods and services, reflecting changes in overall household expenditure. #### 4.1.3 Importance of the CPI in Belgium In Belgium, the CPI is used to determine inflation. A related index, the health index (gezondheidsindexcijfer), excludes certain products like gasoline, alcohol, tobacco, and diesel, and is used for wage indexation. This wage indexation mechanism, often linked to a moving average of the health index and a specific threshold (spilindex), aims to maintain purchasing power by automatically adjusting wages, pensions, and social benefits when inflation exceeds a certain level. ### 4.2 The phenomenon of inflation Inflation is defined as a sustained general increase in the prices of consumer goods. The inflation rate is calculated using the CPI. #### 4.2.1 Understanding inflation A consistently rising CPI indicates inflation, leading to a decrease in the purchasing power of money, meaning consumers can buy less with the same amount of income. The inflation rate is calculated as: $$\text{Inflatie (\%)} = \frac{\text{Indexcijfer jaar } x - \text{Indexcijfer jaar } (x-1)}{\text{Indexcijfer jaar } (x-1)} \times 100$$ The opposite of inflation is deflation, a general decrease in the price level. While it might seem beneficial, deflation can be detrimental to the economy as consumers and businesses postpone spending and investment, leading to reduced demand, production, and increased unemployment. #### 4.2.2 Causes of inflation Inflation can arise from three primary causes: 1. **Cost-push inflation (kosteninflatie / aanbodinflatie / structurele inflatie):** This occurs when businesses pass on increased production costs to consumers to maintain profit margins. Examples include rising oil prices or increased labor costs per unit of product that outpace productivity gains. If wage increases are sought to compensate for these rising costs, it can trigger a wage-price spiral. 2. **Demand-pull inflation (bestedingsinflatie / vraaginflatie / conjuncturele inflatie):** This happens when the demand for goods and services exceeds the economy's production capacity, typically during periods of strong economic growth (hoogconjunctuur). Businesses, facing high demand and customer traffic, raise prices to maximize profits. 3. **Monetary inflation (monetaire inflatie):** Based on the quantity theory of money, this cause attributes inflation to an excessive increase in the money supply. According to the equation of exchange (Fisher's equation), the money stock multiplied by its velocity must equal the price level multiplied by the volume of transactions. If the money supply grows faster than the real economy's capacity to produce goods and services, and production cannot increase further, prices are driven up. #### 4.2.3 Consequences of inflation While a moderate inflation rate (around two percent) is generally considered acceptable and can stimulate spending and make borrowing attractive, high inflation can have negative consequences: * **Redistribution of wealth:** Creditors lose out as the real value of repayments decreases, while debtors benefit. * **Erosion of purchasing power:** The real value of financial assets with fixed nominal values, such as bonds, declines. Individuals whose incomes are not fully indexed to inflation experience a loss of purchasing power. * **Reduced international competitiveness:** If a country's inflation rate is higher than that of its trading partners, its exports become more expensive, and imports become cheaper, potentially leading to a trade deficit. * **Substitution of labor for capital:** When wage increases outpace productivity gains, labor becomes relatively more expensive than capital, potentially leading to structural unemployment as businesses substitute capital for labor. ### 4.3 Combating inflation Maintaining low and stable inflation is a primary objective for monetary authorities, such as the European Central Bank (ECB) in Europe. The strategies employed depend on the cause of inflation. #### 4.3.1 Policies to combat inflation * **For cost-push inflation:** * **Income and price policies:** This can involve wage moderation measures, such as prohibiting wage increases above a certain percentage. * **Price controls:** Governments may implement full or selective price freezes. * **For demand-pull inflation:** * **Restrictive monetary policy:** The central bank can limit the money supply by increasing key interest rates, such as the base refinancing rate. This makes borrowing more expensive, thereby dampening demand. * **Fiscal policy:** Governments can reduce aggregate demand by: * Increasing taxes. * Reducing government spending or transfer payments. > **Tip:** The effectiveness of these policies often depends on the coordinated efforts of both the central bank and the government. > **Example:** If inflation is driven by excessive consumer spending fueled by easy credit, the ECB might raise interest rates to make loans more expensive. Simultaneously, the government might consider increasing taxes to reduce disposable income and thus consumer spending. --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Inflation | A sustained increase in the general price level of consumer goods and services in an economy over a period of time, leading to a decrease in the purchasing power of money. | | Consumer Price Index (CPI) | A statistical measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care; it is calculated by the national statistics office and used to assess price changes over time. | | Index Number of Consumer Prices | A key economic indicator used to measure the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. It reflects the evolution of prices and is used to calculate inflation. | | Representativeness (in index construction) | The characteristic of an index that its basket of goods and services accurately reflects the purchasing habits and the overall consumption patterns of the target population. | | Flexibility (in index construction) | The ability of an index to be regularly updated and adjusted to incorporate new products and reflect ongoing changes in consumer behavior and market dynamics. | | Weighting (in index construction) | The process of assigning coefficients or weights to different products or services within an index basket to reflect their relative importance in the overall consumption expenditure of households. | | Chain index | An index that is updated annually, typically in January, to ensure it remains representative of current consumption patterns and to prevent measured inflation from being distorted by an aging index. | | Simple Price Index | A calculation that measures the price change of a single product or service relative to a base period, often expressed as a percentage. It is a component in calculating more complex indices. | | Synthetic or Composite Index | A single numerical indicator that summarizes the price evolution of a group of products or services by taking the weighted average of their individual price indices. | | Weighted Composite Index | A composite index where the price indices of individual items are multiplied by their respective weights (representing their importance in consumer spending) before being averaged to provide a more accurate reflection of overall price changes. | | Deflation | A sustained decrease in the general price level of goods and services, often associated with a contraction in the money supply and credit, and typically negative for economic growth. | | Cost-push inflation | Inflation that occurs when the prices of goods and services rise due to increases in the costs of production, such as wages or raw material prices, which businesses pass on to consumers. | | Demand-pull inflation | Inflation that occurs when there is an increase in aggregate demand for goods and services that outpaces the economy's ability to produce them, leading to price increases as consumers compete for limited supply. | | Monetary inflation | Inflation caused by an excessive increase in the money supply, as described by the quantity theory of money, leading to a decrease in the value of money and a rise in prices when production capacity is fully utilized. | | Quantity Theory of Money | An economic theory stating that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. | | Fisher's Equation of Exchange | A formula that states the money supply multiplied by the velocity of money equals the price level multiplied by the quantity of goods and services traded: $M \times V = P \times T$. | | Wage-price spiral | A self-perpetuating cycle where rising wages lead to higher prices for goods and services, which in turn leads to demands for even higher wages, fueling ongoing inflation. | | Health index | A specific price index that excludes certain products like gasoline, alcohol, and tobacco from the standard consumer basket; it is often used for wage indexation in Belgium. | | Wage indexation | A system that automatically adjusts wages, salaries, and social benefits in response to changes in a specific price index, such as the health index, to maintain purchasing power. | | Threshold index (Spilindex) | A predetermined level of price increase, often a certain percentage higher than the previous level, that triggers automatic adjustments in wages, pensions, and benefits. | | Purchasing power | The amount of goods and services that can be bought with a unit of currency; it decreases when inflation rises and increases when inflation falls. | | Nominal GDP | The Gross Domestic Product (GDP) valued at current prices, reflecting both changes in the quantity of goods and services produced and changes in their prices. | | Real GDP | The Gross Domestic Product (GDP) adjusted for inflation, reflecting only changes in the quantity of goods and services produced, providing a measure of economic growth. | | Creditors | Individuals or entities to whom money is owed; they are negatively affected by inflation as the real value of the money they are repaid decreases. | | Debtors | Individuals or entities who owe money; they are often favored by inflation as the real value of the money they repay is less than the real value they borrowed. | | Financial assets with fixed nominal value | Investments like bonds that pay a fixed amount of interest and principal, whose real value is eroded by inflation. | | Export decline and import increase | A situation where a country's products become more expensive relative to those of other countries due to higher inflation, leading to reduced exports and increased imports. | | Substitution of labor by capital | The replacement of human workers with machinery or technology, often driven by rising labor costs relative to capital costs, potentially leading to structural unemployment. | | Quantitative structural unemployment | Unemployment that arises from a mismatch between the skills of the workforce and the demands of the job market, often exacerbated by technological changes or shifts in industry structure. | | Monetary policy | Actions undertaken by a central bank to manipulate the money supply and credit conditions to stimulate or restrain economic activity, often aimed at controlling inflation. | | Fiscal policy | The use of government spending and taxation to influence the economy, which can be used to combat inflation by reducing aggregate demand. | | Interest rate | The cost of borrowing money or the return on lending money, influenced by central bank policies to manage inflation and economic growth. | | European Central Bank (ECB) | The central bank responsible for monetary policy in the Eurozone, tasked with maintaining price stability and managing inflation within member countries. |