2.1 - Inflation Flashcards
Measures of economic performance
Inflation
- Inflation refers to the sustained increase in the general price level of goods and services in an economy over time.
- It leads to a decrease in the purchasing power of money.
Deflation
- Deflation is, characterised by a sustained decrease in the general price level.
- It increases the purchasing power of money
What does deflation suggest about the economy
Indicates a slowdown in the rate of growth of output in the
economy
Disinflation
- Disinflation occurs when the rate of inflation declines but remains positive.
- Prices are still rising, but at a slower rate than before.
Consumer Prices Index (CPI)
- measure of the average level of prices in the UK,
based on a representative basket of goods and services purchased by an average household - Calculating percentage changes in CPI (prices of this basket) measures inflation rate
Calculating consumer price index inflation rate
CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100.
Limitations of CPI in measuring the rate of inflation
- Substitution Bias
- CPI assumes constant consumption patterns, whereas consumers often adjust their purchases in response to changing prices.
- This can lead to an overestimation of inflation. - Quality Changes
- CPI may not adequately account for quality improvements in goods and services over time.
- This can result in an overestimation of price increases. - It does not include the price of housing and so, since this has tended to
rise more than the price of other goods, the data may be lower than it should be.
Retail Prices Index (RPI)
- RPI is another measure of inflation in the UK that includes a broader range of expenditures than CPI.
It is used for various purposes, including index-linked bonds and some pension calculations. - RPI tends to produce a higher inflation rate than CPI because it includes housing costs and uses a different formula.
Causes of inflation
- demand pull
- cost push
- growth of the money supply
Demand-Pull Inflation
Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, leading to upward pressure on prices.
Factors contributing to demand pull inflation
Factors like increased consumer spending, business investment, or government expenditure can contribute to demand-pull inflation.
Cost-Push Inflation
Cost-push inflation arises when production costs increase, causing firms to raise prices for consumers to maintain profitability.
Factors contributing to cost push inflation
Factors like rising raw material prices, higher wages, supply chain disruptions, supply shocks (Eg: natural disasters,conflicts) can lead to cost-push inflation.
Growth of the Money Supply
- An increase in the money supply, not matched by a corresponding increase in economic output, can lead to excess demand for goods and services causing an upward pressure on prices and possibly resulting in inflation.
Example: Central banks printing excessive amounts of money can contribute to inflationary pressures.
Effects of Inflation on Economic Agents
> Consumers
- Inflation erodes the purchasing power of money, reducing the real value of savings.
> Consumers who have saved will lose out as their money is worth less. - Fixed-income earners may experience reduced real incomes and so will have less disposable
> could cause a fall in living standards as consumers are poorer in real terms - Those who are in debt will be able to pay it off at a price which is of cheaper value, but those who are owed money lose out because the money they get back is of cheaper
value. - Inflation has psychological effects on consumers: because prices are rising, they
may feel less well-off, even if their income is rising in line with inflation, and so this may cause them to decrease their spending.
Effects of Inflation on Economic Agents
> Firms
- Firms may face rising production costs, reducing profit margins.
> They may adjust prices upward to maintain profitability. - If inflation in Britain is higher than other countries, British goods will be more
expensive. - They will become less competitive and make them more difficult to
export. - This will also affect the balance of payments.
- effect of changing prices is that firms will have to calculate new prices then
change their menus, labelling etc. and this can be expensive
Effect of deflation
- Deflation encourages people to postpone their purchases as they
wait for the price to fall further. - People will be more likely to save as the value of their money will rise in the future
- and they will be prevented from borrowing as deflation means the real value of their debt increases.
> This can lead to a fall in demand for goods, leading to a fall in firms’ profit, and in business confidence which can lead to a long term reluctance to invest. - Deflation could cause some staff to lose their jobs as there is a lack of demand
meaning firms see a fall in profit and have to decrease staff to cut costs
Effects of Inflation on Economic Agents
> Government
- Inflation can increase the cost of servicing government debt, diverting resources from other public spending priorities.
- If the government fails to change excise taxes (taxes at a set amount) in line
with inflation then real government revenue will fall. - However, if they fail to change personal income tax allowances (the amount a worker can earn tax free) then real
government income will increase and taxpayers will have less money.
Effects of Inflation on Economic Agents
> Workers
- If workers do not receive yearly pay rises of the rate of inflation, they will be worse off because the purchasing power of their money has decreased and so their living standards will decrease.
> Those in weaker unions tend to be most
affected as they are unable to win wage rises in line with inflation.
Debt deflation spiral
- Real value of debt rises when deflation occurs.
- This is because the real value of money increases and so does the value of debt.
- Leads to a decrease in consumption and investment and so price levels continue to fall as a result of a decrease in aggregate demand.
