2.1.2 Inflation Flashcards
What is the government macroeconomic objective for inflation?
2% (plus or minus 1)
What are the adverse effects of inflation?
- Rising prices means that the value of what savings can buy falls
- Disrupts knowledge of prices in a market
What did inflation reach to in 1975?
24.1%
How does the Consumer Price Index (CPI) work?
The Office for National Statistics (ONS) collects prices on 710 goods and services from shops and online sites and the prices are updated every month to find out what consumers spend their income on. From this, a basket of goods is created and measures average price change of the goods
Limitations of CPI: (5)
- It is impossible for the figure to take into account every single good that is sold in the country.
- Different households spend different amounts on each good and so therefore the CPI measures an average rate of inflation, so it is not accurate for households who do not own cars.
- Different demographics have different spending patterns
- Difficult to make comparisons with historical data. It was only used since 1996 with estimates going back to 1988 which means that levels of inflation using CPI can only be accurately compared back to then.
- Does not include 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.
Difference between Retail Price Index (RPI) and Consumer Price Index (CPI)?
- RPI includes housing costs such as mortgage and interest payments and council tax
- RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.
Causes of inflation: (2)
- Demand Pull: Inflation can be caused by an increase in AD
- Cost Push: Inflation can be caused by a decrease in AS
What are the main triggers of Demand Pull inflation? (4)
- A depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper
- Fiscal stimulus in the form of lower taxes or more government spending. This means consumers have more disposable income, so consumer spending increases
- Lower interest rates makes saving less attractive and borrowing more attractive, so consumer spending increases
- High growth in the UK export markets means UK exports increase and AD increases
What are the main triggers of Cost Push inflation? (5)
- Raw materials become more expensive, such as when oil prices rise
- Labour becomes more expensive. For example through trade unions
- Expectations of inflation: If consumers expect prices to rise, they may ask for higher wages to make up for this, and this could trigger more inflation
- Indirect taxes could increase the cost of goods such as cigarettes or fuel, if producers choose to pass the costs onto the consumer
- Depreciation in the exchange rate, which causes imports to become more expensive, which pushes up the price of raw materials
Growth of the money supply on inflation
A cause of inflation could be too much money in the economy (for instance the Bank of England printed more money) if people have access to money they will want to spend it.
Effects of inflation on consumers: (4)
- If people’s incomes do not rise with inflation then they will have less to spend, causing a fall in living standards
- 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 because the money they get back is of cheaper value
- Consumers who have saved will lose out as their money is worth less
- 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 firms: (4)
- If inflation in one country is higher than in other countries, goods will be more expensive. They will become less competitive and make them more difficult to export. This will also effect the balance of payments
- Deflation encourages people to postpone their purchases as they wait for the price to fall further. This can lead to a fall in demand for goods, leading to a fall in the firms’ profit, and in business confidence which can lead to a long term reluctance to invest
- Difficult to predict and so firms can’t plan accordingly
- Workers may demand higher wages, increasing the cost of production for firms
Effects of inflation on governments: (2)
- If the government fails to change excise taxes (taxes at a set amount) in line with inflation then real government revenue will fall
- Government will have to increase value of state pension and welfare payments because the cost of living is increasing
Effect of inflation on workers: (2)
- Real incomes fall with inflation, so workers will have less disposable income
- 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
What is indexation?
Wages or taxes are increased in line with inflation. An example of this is workers negotiating with employers for wage rises in line with the predicted CPI or RPI
