General price level

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  • Created by: samadhi
  • Created on: 08-04-13 15:12

General price level

HOW IS THE VALUE OF MONEY MEASURED?

  • The value of money is its purchasing power, that is, the amount of goods and services that can bepurchased with a given amount of money. 
  • The value of money depends on the general price level.
  • In other words, changes in the price level cause changes in the purchasing power of money. 
  • When the general price level rises, the value of money falls because the given amount of money will buy less goods and services.
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General price level

  • In practice, changes in the price level and in the value of money are measured by a price index.
  • This is a statistical measure that expresses the average price of some group of commodities in some year as a percentage of the average price of the same commodities in some other year.

RPI calculation involves 3 main stages 

  • 1. A survey to find out what families buy and how much they specd on particular items - this provids the weights 
  • 2.Recording how much the prices of some 600 selected items have changed - this information is collected from all main typesof retail outlets, as well as from Gas , water, electricity and transport suppliers at a base date. 
  • 3. The percentage change in price for each item is then multipiled by its weight- from this the average change in the RPI is determined. 
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General price level - problems in measuring

PROBLEMS IN MEASURING CHANGES IN THE VALUE OF MONEY:

  • 1. The choice of the base year
  • 2. Finding a representative group of commodities
  • 3. Computing the weights
  • 4. The price index is not able to take into account changes in quality
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General price level - problems in measuring

1. The choice of the base year:

  • The selection of the base year is a very complicated task.
  • The prices in the chosen base year should be reasonably steady. Periods of severe inflation, deflation or recession should be avoided.
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General price level - problems in measuring

2. Finding a representative group of commodities: 

  • In selecting commodities to include in the basket of goods, accurate information on expenditurepatterns of households is needed.
  • But there are great difficulties in collecting such data.
  •  People are unwilling to disclose their expenditure truthfully.
  • Besides, different income groups do not share the same basket of goods.
  • Even people with the same income do not buy the same commodities in the basket.
  • Thus, the construction of consumer price index involves a lot of guesswork.
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General price level- problems in measuring

3. Computing the weights:

  • The assignment of weights also involves a certain amount of guesswork.
  • The weights in the index are devised to take account of the relative importance of different goods in the pattern of expenditure.
  • But there is great difficulty in obtaining information because people are usually reluctant to reveal how they spend their income.
  • Furthermore, this weight will not necessarily be typical of what each household consumes.
  • Each household consume bundles of goods and services that differ from one another.
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General price level - problems in measuring

4. The price index is not able to take into account changes in quality:

  • A commodity may not have changed in price but its quality may have fallen. 
  • Conversely, a good may be more expensive because it is of a better quality than before. Such changes in quality affect the consumer’s standard of living but cannot be reflected in the price index.
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