Topic 6: The Theory Of Money - Economics Notes Form 5:- Economics Form 5 Topics | Form Five Notes by Tanzania Institute of Education | Economics Notes Form 5 to 6 - For A level | Economics Form Five Notes Za A-level PDF Download
THE THEORY OF MONEY
Money refers to anything of value which is generally acceptable by the whole society to act as a medium exchange.
Money is accepted not for its own sale but because others will accept it in exchange for goods and services. Therefore demand for money is a derived demand.
It is a legal tender meaning that everyone in the country concerned must accept it in settlement of debts.
IMPORTANT TERMS
1. Legal tender.
Is money for specific country which must by law be accepted for the discharge of debts.
Refers to the total stock of money and includes foreign currencies which are not generally and acceptable for the discharge of debts.
2. Token money.
Refers to the coins whose metal value is less than face value instric value of money is the commodity value of materials used to make money.
Extric value of money – Is the value of money interms of its ability to purchase goods and services.
3. Fiat money.
Is issued in the directive of the government irrespective of the level of economic activity e.g. money printed to Jinana the car
Fiduciary issue – Is the money which is issued and not backed by gold.
4. Quasi money/near money.
Refers to risk free assets which are easily converted into cash e.g. bonds, foreign currencies.
Refers to ease with which an asset can be converted into cash. Liquidity assets are those which are easily converted into cash with no risk of cash loss e.g. cash is the most liquid asset.
Liquidity – Refers to the difficulty with which assets is converted to cash. Liquid assets are less profitable than illiquid assets e.g. long term bond/earn more interests than short term bond.
FEATURES OR CHARACTERISTICS OF GOOD MONEY5
1. It must be generally (acceptable) in the society i.e. all the people in the country must be confident that it will be accepted by others.
2. It must be easy to transport e.g. it must not be heavy in relation to its value.
3. It must be divisible to smaller domination to make possible smaller transaction e.g. Tanzania currency is divided into 50/=, 100/=, 1000/=, 5000/=, 20000/=, 50000/=, and 100,000.
4. It must be durable i.e. money must not be perishable so as to function as a store of value.
5. Must be relatively scarce as money must be relatively scarce in order to maintain its value otherwise would lose its value if it is plenty and people prefer to keep their wealth inform of property.
6. Homogeneity:-One piece of money i.e. money should be similar, for instance a ten shilling note should be similar to all other ten shilling notes used in a country.
TYPES AND EVOLUTION OF MONEY
Money is classified according to how it involved in history as follow.
i) Barter system. This was the earnest form of exchange where commodities were exchanged directly for other commodities.
ii) Use of commodities of high use value e.g. salt, tobacco, corn.etc
They were used to determine the value of other commodities. Such commodities were used because of their value and ability to society human wants. However they are perishable and even bulky.
iii) Use of durable commodities of iron, copper, gold,courier shells, silver heads e.t.c However not all commodities were scare hence they could not a good media of exchange.
iv) Use of rare materials i.e. gold and silver those were used because their scarcity and durability.
v) Paper money
In the beginning people used to deposit their gold with the gold smith, the custodians of gold who were living at that time. In turn the gold the gold smith could give them receipts which they were to use to get back their gold.Later people started to use receipts to settle debts and obligation because such receipts were as good as gold in the beginning paper money was as good and gold because it was fully backed by gold.
vi) Deposit money:
This is created by commercial bank in the process of accepting deposit and landing using cheque. (Credit creation).
ADVANTAGES OF BARTER ECONOMY OVER MONETARY ECONOMY.
It preserves foreign exchange i.e. it enables exchange to take place without working for exchange.
It widens the market of commodities.
It encourages trade among less developed countries which lack foreign currencies.
The effect of price fluctuation is avoided since bargaining is in terms of physical quantities.
DISADVANTAGE OF BARTER ECONOMY.
There is no generally acceptable means of settling dept. and obligations.
There is no measure of value of reflecting the relative quantities and quantities of commodity to be exchanged.
There no standard of differed payment for means to facilitate payments to debts and transactions to future time.
There was nothing to facilitate specialization to take place since there is no generally acceptable way of paying wages, rent and interest.
There is problem of transporting the bulky commodities to use in exchange.
Most commodities appear in plenty and therefore lose value easily.
Most of the commodities are not divisible to smaller denomination to make smaller transaction possible.
It is difficult to get commodities which are homogeneous to use as means of setting obligations.
Problems of double coincidence.
VALUE OF MONEY
The value of money means the purchasing power of money i.e. the amount of commodities a unit of money can purchase the value of money depends on the price level.
If the price is higher, the value of money is lower and if the price is lower, the value of money is higher.
EFFECTS OF CHANGE IN THE VALUE OF MONEY:
Effect when the value of money increases.
a) The business activities will be stimulated due to increase in purchasing power.
b) There will be less risk to produce (loss) due to sureness of produces to market their products.
c) Profit margin rises due to increase in revenue as a result of increase in purchasing power in the economy.
d) Output also rises.
Produces will be stimulated to increase output due to increase input.
e) Cost of production becomes low hence production increase.
Effect when the value of money decreases.
Cost of production increases or rises hence reducing down production.
It becomes difficult to adjust wages.
Purchasing power of individuals will decrease due to increase in price of goods and services hence affects living standard of people.
Profit Margin will decrease due to increased cost of production.
DEMAND FOR MONEY
Refers to the willingness of people to hold money in cash rather than other assets like bonds, bills and other government securities.
The question why do people hold money? Can be explained by the following;
The quantity theory of money.
The Keynesian demand for money theory.
THE QUANTITY THEORY OF MONEY.
According to prof. Irving fisher money is like other commodity to the market.
-As the quantity supply increases the price increase i.e. the value of money will decrease and when the quantity supplied decreases the prices will decrease, hence the value of money increases.
NOTE:
According to fisher the value of money depends on quantity of money in circulation or level of transaction e.g. when the quantity of money is double the price will also be double but the value of it will fall a half.
The theory can be explained by the following equation;
MV=PT.
Where,
M= Stock of money.
V=the velocity of money in circulation.
P= General Price level.
T= Level of transaction.
MV= Amount of money spent on purchasing commodity.
PT=Value of goods and services sold in an economy.
ASSUMPTIONS OF THE THEORY
Velocity of money should remain constant.
The proportion of increase/decrease in proportion is inverse proportional to the quantity supply of money.
Number of transaction should remain constant.
Absence of hoarding i.e. all the money in circulation should be used for transaction.
Quantity and velocity should be credit for transaction.
There no barter trade i.e. operating in monetary economy.
CRITICISM OF THE QUANTITY THEORY OF MONEY:
The quantity theory of money have been rejected or criticized on the following basis;
The theory based on weak assumptions because all variables are assumed to be constant i.e. V & T in actual sense the velocity of money and number of transaction do not remain constant when the quantity of money changes.
Price of different commodities do not change at the same time as the theory explains in price changes differently on condition of demand and supply.
The theory is based on the supply side ignoring the demand side of money i.e. it is both demand and supply of money which determines price.
It is just truism and not theory. The theory is inadequate because it does not consider the interest rate which is the basis of monetary theories.
The theory ignores the influence of the government in the price level is through price ceiling and price floor.
Fisher considers money as a medium of exchange and to ignore the direct exchange of goods for goods which exist in some part of different money.
Increase in price can be brought about by scarcity (e.g. existence of monopoly market but not necessary due to increase in money supply.
KEYNESIAN THEORY OF DEMAND FOR MONEY
According to Lord John.M.Keynes those are main reasons as to why people hold money (demand).
Transaction motive.
Speculation motive.
Precautionary motive.
a) TRANSACTION MOTIVE.
Money is demanded for facilitating the day to day uses i.e. to buy everyday requirements such as food, clothes e.t.c
The quantity of money demanded for transactional motive is direct proportional to the person’s income.
-Also the longer the payment period the more money for transaction and vice verse.
b) PRECAUTIONARY MOTIVES.
Individuals hold extra money as a precaution against unseen events or circumstances e.g. sickness e.t.c this additional money held to meet unexpected events in the future is said to be held for precautionary motives depending on person’s nominal income is related to income.
C) SPECULATIVE MOTIVES.
If money is held in excess amount required for transaction and precautionary motive then hold for the speculation purpose speculative demands on the future trend on the interest rate which will prepare to converts their asset into investment e.g. purchasing bond rather than money in cash when interest rate is low, investors prefer to convert assets into cash.
Therefore demand for money for speculative motive is inversely related to interest rate i.e.
People hold money for earning income through speculation. This depends on the rate of interest.
Graph for illustration.
From the graph when the rate of interest is expected to fall from Or2 to , speculators convert bonds to cash and therefore demand for money M2 M1 to avoid capital loss when the rate of interest is expected to increase from Or 1 to Or2 speculators buy bonds and hence demand loss money (OM2). This liquidity trap shows the point below which the interest rate would be too low to encourage speculation to invest in bond and as a result only money.
FINANCE MOTIVE
People hold money to finance on gaining investment in which capital has been sink such money held would constitute the variable costs of such investment.
NB: Determinants of demand for money on addition to Keynesian demand for money theory others are;-
GENERAL PRICE LEVEL
In high demand for money is high because of the low value of money of low demand for money low because of the high value of money.
MONEY SUPPLY.
Refers to the money in circulation plus money current savings and time deposit accounts.
MV2 = M1 + saving and time deposits.
= M1 + SD +TD.
Where
M1 = CC +DD
CC = Currency in circulation.
DD = Demand deposits.
This definition treats money as medium of exchange and therefore considers only money which in reality it is available to be used to facilitate exchange.
MONEY SUPPLY:
Refers to the volume of money in an economy. There are several definitions of money supply as follows;-
Narrow definition of money supply.
Money supply as money in hands of the public plus money on demand deposits (current account).
M1 = CC + DD
Where
CC = Currency of circulation
DD = Demand deposits.
This definition treats money as a medium of exchange and therefore considers only money which in reality it is available to be used to facilitate exchange.
2. BROADER DEFINITION OF MONEY SUPPLY.
Refers to the money circulation plus money current, savings and time deposited accounts.
Mv2 = M1 + saving and time deposits.
= M1 + SD + TD.
Where
M1 = CC + DD
S = Saving
TD = Time deposits.
;- This takes money to be a store of value.
Others definition: includes the definitions of other like bonds and foreign currencies.
i.e. M3 = M2 + M1 + near money (Quasi)
NB:
Near money (Quasi) refers to the assets that can easily be connected with cash.
TYPES OF MONEY SUPPLY.
Exogenous (discretionary) supply of money.
This is determined by the monitoring authority which may be central bank or ministry of finance. Exogenous supply of money is usually assumed fixed.
This depends on the level of economic activities e.g. output of interest e.t.c
DETERMINANTS OF MONEY SUPPLY.
1. Printing more money by monitoring authority.
When the government undertakes run short of money, more money can be printed to finance them. This is called financed accommodation.
Demonetization is withdrawing all money in circulation reduces money supply.
2. Government borrowing from the central Bank.
This also implies printing of money since the central bank has no money to lend.
When the central bank buys the securities (e.g. bonds) from the public money supply increases but when the central bank sells securities to the public, money supply is reduced.
3. Balance of payments (BOP) surplus when export exceeds imports the surplus foreign exchange for local currency such money circulates in the economy and the vice versa during balance of payment deficit.
Foreign capital inflow e.g. tourist who exchange foreign exchanges in local currency spends during their stay in the country and the vice versa during capital out flow.
4. Special deposits
If increased or if imposed by the central bank reduces money supply.
5. Credit by commercial banks.
This act by commercial banks using the cheque facility expands to result into greater volume of credit than the amount originally lend out. The increase in money supply in the currency.
This is the rate in which the central banks charge commercial banks from the loan given to them.
The increase interest rate to the public. The increase in interest rate will discourage borrowing and encourage saving hence decrease in supply and vice versa when the bank into decrease.
6. Selective credit control i.e.
If few factors get credit money supply reduces while of credit is not restricted money supply increase.
INFLATION
Refers to the continuous or persistent increase in the general price level of all commodities in an economy.
Qn: Find the inflation rate:
Inflation rate is defined simply as the velocity of the increase in general price levels and it is give by.
P = Pt – (Pt – 1)/ Pt-1
Where
Pt = current price
Pt – 1= Base year price
P = Inflation rate.
TYPES OF INFLATION:
Types of inflation can be classified according to its causes and rate of spread or intensity.
Types of inflation according to its causes
Demands pull inflation.
Costs push inflation.
Others types of inflation are.
i) Imported.
ii) Structure.
DEMAND PULL INFLATION
From the diagram,
Increase in aggregate demand from Do to DI leads to increase in price from Po to PI which is the inflation point.
CAUSES OF DEMAND PULL INFLATION:
1. Rapid increase in population.
The higher the population, the higher demand of goods and services.
2. Decrease in government taxes.
Lead to increase in personal disposable income which increases the purchasing power of an individual.
3. Increase in wages or income of an individual.
Increase in people income leads to increase in purchasing power.
4. Increase in government expenditure.
This will lead to increase in supply of money increased people will increases the rate of purchasing power which is in aggregate demand.
Increase in capital inflow thorough exports leading to increase in money supply.
Printing more money by the government through expansion of monetary policies.
Increase in exports of essential goods which leads to increase in foreign exchange hence more supply of money which increase aggregate demand.
Decrease in imports of essential goods which lead to increase in aggregate demand for such goods.
Decrease in output as a result of restriction by monopolist cause artificial shortage in an economy which will cause increase in demand for those goods.
MEASURE TO CONTROL DEMAND PULL INFLATION
Increase in taxation (direct) will reduce personal disposable income.
Production in government expenditure this will reduce supply of money in the economy.
Reduction in wages of workers.
Increase in importation of essential goods so as to reduce the problem of scarcity.
Use restrictive monetary policies i.e. Contraction monetary policies that reduce money supply in the economy.
Discourage rapid population pressure so as to reduce the demand for goods and services.
Encourages saving which will reduce aggregate goods demand.
COST PUSH INFLATION
Is the kind of inflation caused by increase in cost of production i.e. increase in wage, rent interest, also increased cost of equipments which can be used for production process.
From the graph increases in price of factors of production leads to the decrease in the supply of goods and services from Oyo to Oy.
CAUSES OF COST PUSH INFLATION.
High cost of raw materials especially those which are imported.
High advertising cost.
High wages to workers.
Trade units.
Increase in transport cost due to increase in price of fuel in the world market.
CLASSIFICATION OF INFLATION ACCORDING TO THE DEGREE OF INTENSITY. (SPEED)
1. Creeping or mild or gradual inflation.
This refers to the slow increase in general price level. The increase in the general price level is less than 3%. It encourages production and it does not distort relative prices or income severely.
2. Walking or trotting or moderate inflation.
This is where the increase in the general price level is a single digit or less than 10% per annual. It is a warning to the government to put measures to control it before it goes out of hand.
3. Running inflation.
This is when prices increases at the rate of 10 – 20 percent per year/annual. It requires strong measures to control it.
4. Hyper inflation or run away or Galloping inflation.
This is the rapid rise in the general price level where inflation ranges from 20% even more than 100% per annual.
Inflation becomes uncountable and prices rises many times every day. Money losses value and people prefer to hold real goods or assets than money.
OTHER FORMS OF INFLATION:
Wages – wages inflation.
This occurs due to inter firm or intersect or common wages among workers. A rise in wages in one sector or firm causes revision of wages in similar occupation in the economy. As enter preview increase wages total cost and prices also increases.
STRUCTURAL OR DEMAND SHIFT INFLATION:
This is occurring as a result of a combined element of cost push and demand pull inflation.
It occurs when there is a structure change in element of situation e.g.
In a situation where some industries are expanding while others are declining in the case of expanding industries higher wages has to be paid in order to attract labour increasing in wage cause inflation of a result of increase in cost of production.
Increase in production may result to the increase in demand for goods and services.
CAUSES OF STRUCTURAL INFLATION:
Temporary break down of economic sectors like agricultural sector and industry sectors.
Shortage of productive inputs i.e. if factors of production are in shortage. There will be low production in the economy hence aggregate demand being greater than aggregate supply.
Political instabilities. This will discourage production.
Speculation by business. This cause artificial shortage by holding their goods expecting that they will get more money in the future.
Shortage of foreign exchange to increase importation.
Poor transport system to reach goods in all parts of the country.
MEASURE TO CONTROL STRUCTURAL INFLATION
Improvement of transport system so as to enable goods and services to reach all parts of the country.
Modernization of agriculture as to improve agricultural activities.
Provision of productive input i.e. factors of production should be available in cheap price.
Creation of goods in a conducive atmosphere which promotes production.
Price control measures.i.e there should be price commission which will be responsible in setting minimum and maximum prices (price ceiling and price floor).
IMPORTED INFLATION
Is a type of inflation which is the result of imported goods and services from the country which is affect by inflation.
CAUSES OF IMPORTED INFLATION:
Importation of goods of high prices from countries experiences.
Rising prices in international market.
Import shortage.
Inelastic demand for imports.
Protection against imports i.e. through imports duties.
Expansionary / monetary policies which lead to high import demand.
EFFECTS OF INFLATION
1. Effects on production.
Production takes place in the two periods is short run plus long run period.
Effect of inflation in the short run.
In the short run increase in the price will encourage production because producer will sell their product at higher price.
At this period.
a. Wages or salaries cost adjust slowly.
b. Fixed charges such as result electricity, water supply and other charges adjust slowly.
c. Contacts and supply of raw materials covers long period until further orders are placed. The producer will use profit earned to increase production and possibly employment to stimulate demand.
2. Effect of inflation in the long run.
Inflation will discourage production as the money value falls hence all the cost of production will rise hence causing negative effects on production.
3. Effects of inflation in the long run.
Producers or profit earners.
4. These gain most during inflation as noted profit margin increase considerably during inflation but in short run only.
Wages and salary earners.
These also looses during inflation although not as much as fixed earners. Their loses will eventually be reduced due to wages and salary adjustment.
During inflation the value of savings falls i.e. rate fall this discourages saving and encourage wings.
Lenders
During inflation lenders tends to lose due to the fact that they are paid back their money when its value is low.
Social-political effects
EFFECTS OF INFLATION (GENERALLY)
Negative effects of inflation
Agriculturalists lose because prices of agricultural commodities tend to lay behind inflation. Their savings welfare and productivity falls.
Workers suffer when there is inflation because use wages kind to buy behind inflation.
The standard of living of fixed income consumers (like pension earners those who depends on past saving) falls.
It discourages people from saving in financial institutional because of fear that their money would lose value. Financial institution is forced to increase the rate of interest and this increases cost of borrowing and leads to further inflation.
It reduces the purchasing power of the majority since it redistributes income from the majority peasants and workers to the majority (business people).
Creditors lose because they are paid back in an inflation currency. This discourages lending by individuals and financial institution.
It leads to political unrest and demand for high salaries by workers. Therefore it increases people fail to meet the high cost of living e.t.c.
Inflation leads to balance of payment (BOP) problem of discouraging exports and encouraging imports. Exports reduce because dislike buying from a country where price are high. Import increase because outsides like to sell in a country where prices are higher.
Inflation may be used against the production of exports whose prices are determined on the world market. Prices remain fixed where as costs of production increase in the domestic currency. People shift to production for domestic markets to fetch higher price.
Where there is hyper inflation there is need to revise plan for tax structure and contacts to match with the new price structures. This is time consuming and can lead to fail are to archive objective of plans and programs.
Inflation to rural-urban migration since it becomes less profit to grow crops in rural area.
People shift to town to start businesses. This discourages agriculture in rural areas and lead to urban unemployment and development of slams in town.
It undermines the external value of the currency which calls for devaluation of the currency. This makes importation of raw materials difficult.
It leads to black market e.g. to create artificial shortages.
POSITIVE EFFECTS OF INFLATION:
Hyper inflation is ineducable in the economy. However mild inflation may be health to the economy in the following ways.
It increases the profit level of business (commercial producers) since cost of production rise lower than price of commodities. This encourages investments.
It makes workers and peasants to work harder to maintain their standard of living after the increase in prices which may provide incentives for people to encourage in economic activities.
It reduces the level of unemployment, since there would be a lot of money to spend and stimulate production and to invest and create more jobs.
It encourages business people to get loans since they would expect money to have lost value of the time of paying back.
It encourages people to produce goods to sell in the domestic market where price is high.
By encouraging urbanization it leads to an increase in demand for food which encourages agriculture.
POLICY FOR INFLATION
Policies for inflation are mainly macro economics policies which aim at stability. Efficiency and fair distribution of wealth. A policy of inflation depends on the causes of inflation. Policy instrument should reduce aggregate demand and increase supply.
A light (restrictive /ideas) monetary policy. This involve the use of various tools of monetary policy to reduce money supply and square consumption.eg increase in bank rates, selling securities to the public, increasing reverse rates etc. Produce money supply and aggregate demand at the extreme the government can also demonetize the currency by declaring the old one useless and new one.
Fiscal policy-This includes the reduction of government expenditure and increase of taxes to reduce aggregate demand. A supply budget where the government collects more revenue than its expenditure is a strong tool. The government can also do internal borrowing to reduce money supply and also postpone repayment of internal debts to the time when inflation is controlled.
Reorganization of distribution channel of goods–e.g. restoring of scarce commodities and rationalization of major distribution channel.
According to the kinked demand curve it does not pay for the oligopoly to the rise or lower price.
Depreciation and Appreciation of a Currency
Depreciation of a currency.
Is when there is a decrease in the value of the domestic currency in relation to the foreign currency purely caused by the market forces of demand and supply of the currency.
E.g. when it was1ksh. = 10Tshs.
And then it was 1ksh. = 20Tshs.
From the above example the Tanzania Tshs has depreciated.
Effects of depreciation of a currency
Increase in exports and they become cheaper.
Import decreases as they become more expensive
As exports increase and import decrease the deficit in the balance of payment reduces.
Depreciation stimulates more production and hence promotion of the domestic industries plus creating more employment opportunities.
Appreciation of the currency
This is when there is increase in the value of domestic currency in relation to the foreign currency purely caused by the market forces of demand and supply of the currency.
E.g.: when 1kshs was 10Tshs and then later on it was
1kshs was 6Tshs, so the Tanzania Tshs has appreciated
EFFECTS OF APPRECIATION OF A CURRENCY
Exports reduce as they become more expensive.
Import increase as they become cheaper.
As import increases and export reduces the deficit in the balance of payment increase results into the balance of payment problem.
Production contract and results into increase in unemployment
Value of Money
Value of Money is the purchasing power of money which is reflected through the amount of goods and services a cent of a currency can purchase.
Value of money can increase or decrease. For example during inflation, value of money decreases and during deflation the value of money increases.
Measuring changes in value of money
Changes in the value of money are measured through price index.
Price index is a figure which measure the relative changes in the price of various commodities from one period to another period. That is to say from the base to the current year.
NOTE: Price index can as well be called the cost of living index as it gives a picture on changes in the cost of living in a certain area from one period to another. Price indices can be producer’s price index, whole seller’s price index, retailer’s price index, etc.
TABLE SHOWS MEASURING CHANGES IN VALUE OF MONEY
Commodity | Price in 1970(Shs) | Price in 1980 (Shs) | Price relative |
A | 20 | 25 | 125 |
B | 5 | 10 | 200 |
C | 15 | 30 | 200 |
D | 40 | 50 | 125 |
E | 200 | 450 | 225 |
Σn=5 | Σ PR=875 |
Commodity | weight | P x in1970 | P x 1980 | PR | W x PR |
A | 5 | 20 | 25 | 125 | 625 |
B | 4 | 5 | 10 | 200 | 800 |
C | 2 | 15 | 30 | 200 | 400 |
D | 3 | 40 | 50 | 125 | 375 |
E | 10 | 200 | 450 | 225 | 2250 |
Æ© = 24 | Æ© = 4450 |
Formula :WPI=Æ©WPR/Æ©W
Lapser’s Price Index(LPI)
This is a base year weight price index therefore it uses the base year value as its weights.
This price index is a better way to get a picture on changes in the value of money, standard of living etc as it makes a comparison between the base and the current year.
1998 | 2000 | |||||
Items | Qty (Kgs) | P x (Shs) | Qty (Kgs) | P x (Shs) | ||
Beans | 2 | 3.2 | 2 | 40 | ||
Sugar | 5 | 2.0 | 10 | 1.5 | ||
Meat | 2 | 5.0 | 1 | 25.0 | ||
Rice | 3 | 1.0 | 8 | 5.0 | ||
Maize flower | 2 | 1.0 | 3 | 7.0 | ||
Interpretation
Price increased by 201%
Cost of living increased by 201%
Standard of living declined by 201%
Saving capacity declined by 201%
Pascal’s Price Index
This is a current year weight price index which is calculated by
PPI = Æ©PnQn /Æ©PnQox 100
Where
Æ© = Summation
Pn = Price in the Current year
Po = Price in the base year
Qn = Quantity in the current year
Using the precious table
PPI = Æ©PnQn/Æ©PnQox 100
Æ©PnQn = (4.0 x 2) + (1.5 x 10) + (25.0 x 1)+ (5.0 x 8) + (7.0 x 3)
= 8 + 15 + 25 + 40 + 21
= 109
Æ©PoQn = (3.2 x 2) + (2.0 x 10) + (5 x 0.1) + (1.0 x 8) + (1.0 x 3)
= 6.4 + 20 + 5 + 8 + 3
=42.4
PPI = 109/42.4 x 100%
PPI = 257.0754-100%
PPI ≈ 157%
Interpretation
Price increased by 157%
Cost of living increased by 157%
Standard of living decline by 157%
Saving capacity declined by 157%
Importance of Price Index
It is important in measuring changes in the general price level between the base and the current year therefore it is from the price index that it can be known whether the prices increase, reduce or remains the same.
Price indices are also important in knowing changes in the value of money over time. Therefore it can be known whether the value of money has increased or reduced.
Price indices are also important in measuring the cost of living between the base and the current year. Therefore it is from price index that it can be known whether the cost of living has increased or decreased.
Price index is also important in measuring in the standard of living between the base and the current year. Therefore it can be known whether the standard of living has increased or decreased.
Price indices are also important to the government and to the employees in the wage policy as it gives a picture on the cost of living and standard of living and hence creating a basic of wage revision.
Price indices are also important in measuring terms of trade, position of the country by use of the price index for export and price index for imports. Therefore price indices are important in showing changes in the terms of trade position of the country.
Price indices are also important in deflating National income from nominal to real through the use of the GDP deflation.
Price indices are also important in comparing the cost of living and standard of living between countries.
Problems experienced in measuring and use of price index
Choice of the base year
It is difficult to get a base year in which prices are relatively stable, this is due to the fact that they are normally ups and down in the prices.
Difficulty in selection of a common represent basket of commodity from the wide range of commodities.
The data problem.
It is difficult and unreliable data on prices and quantities as many consumers do not keep a record of their expenditures.
There are several ways/ methods that can be used to calculate price index but which give different answers this creates a problem in the interpretation.
Change in the prices may be as a result of improvement in quality which may be interpreted as inflation but which is not.
Index numbers have limited use for a long period of time due to the fact that taste and preferences change.
Steps taken in compiling price index.
Choice of an area where the data is to be collected
Choice of a common representative basket of commodities.
Collection of data on prices and quantities
Tabulation of the data
Choice of the appropriate formula and computation Interpretation