Question

People complain that inflation increases the cost of goods and services and therefore reduces their purchasing power. Explain if this complaint is valid in the following situation:

Between 2017 and 2018, the CPI of a small nation rose from 182 to 185. The people’s incomes rose by 3% during that period of time. Explain by using the numbers provided in this example, what happens to their purchasing power.

Answer 1

Ans. Inflation rate, P = (CPI 2018 - CPI2017)/CPI 2017 = (185-182)/182 = 0.01648 or 1.648%

Increase in nominal income, n = 3%

Therefore, Increase in real income, r = n - P = 1.3516%

So, effectively real income of people is rising which means that now they can buy more goods and services. Thus, there purchasing power increases.

Therefore, it is not always true that inflation reduces purchasing power.

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