Question

The consumer Price Index for the different years are as follows.

2003 10.75

2004 89.25

2005 83.34

2006 56.25

1) Calculate Inflation rate for 2003, 2004, and 2005.

2) What kind of fiscal policy will you use to fight against inflation. Explain it briefly.

Answer 1

Since the Consumer Price Index (CPI) can be defined as a measurement which evaluates the weighted average of prices of a basket of consumer goods and services. For example transportation, food and medical care etc.

Inflation=[(CPI2-CPI1)/ CPI1]*100

Since CPI before year 2003, is not given, so inflation rate of 2003 cannot be calculated.

Inflation 2004 =[(CPI2-CPI1)/ CPI1]*100

=((89.25-10.75)/ 10.75)*100

=730.23%

Inflation 2005=[(CPI2-CPI1)/ CPI1]*100

=((83.34-89.25)/89.25)*100

=-6.62%

2.

The inflationary gap arises, when actual output is greater than the potential output. So for closing the gap, government uses Contractionary fiscal policy.

For fighting with the inflation rate, government uses contractionary fiscal policy.

Under Contractionary fiscal policy, therefore government either decreases the government spending or increase tax. So aggregate demand decreases, so AD curve shifts leftward, so price decrease and output also decrease. Hence inflation rate also decreases.