2.1.2 Inflation Flashcards
Inflation
the rate at which the general level of prices in the economy rises - leads to a fall in purchasing power (money worth less/can buy less)
Who is inflation a problem for?
Inflation is not a problem for Purchasing Power Party if incomes are also rising but bad for people who have a fixed income (since income stays, but inflation rises)
Deflation
(opposite of inflation) when the average price level falls
Disinflation
a falling rate of inflation
- The average price level is still going up but slower than before, meaning g/s are relatively cheaper now than a year ago & the Purchasing Power of money has increased
Hyperinflation
the rate of inflation is high & volatile, to the extent that it’s out of control
Types of deflation
Benign vs Malevolent
How do we calculate the rate of inflation?
Using the Consumer Price Index
The Consumer Price Index
examines the weighted average prices of a basket of consumer g/s
- e.g transportation, food and medical care
How do we use the Consumer Price Index?
- is calculated by taking price changes for each item in the predetermined basket of goods and averaging them
- changes in the CPI are used to assess price changes associated with the cost of living
- the CPI is an index number that shows the change compared to a base year/time period
- this is then used to calculate inflation rate
What we need to know for the CPI (how to calculate it)?
- need to know what people buy & how the prices of those things have changed
- need an average/ typical basket of goods so that you know the significance of each of these goods/ services
- then any price changes can be weighted to show significance
- family expenditure survey helps identify the price & content of a typical basket of goods
Problems/ limitations with using CPI to measure inflation
It doesn’t include housing cost, no typical basket, regional differences (typical basket)
The Retail Prices index (RPI)
CPI plus housing costs (e.g accommodation costs & mortgage repayments)
Difference between CPI and RPI
- CPI is lower than RPI
- CPI used for international comparisons
- CPI used for inflation target that the Bank of England’s Monetary Policy Committee is required to achieve
- RPI is used to index various prices & incomes including tax allowances, state benefits, pensions
Causes of cost Push inflation
- Tax (government policy)
- Raw material (importing)
- Labour
How does tax cause cost pull inflation?
- if taxes rise = cost rise
- shifts the AS curve inwards (raising prices)
How does raw material cause cost pull inflation?
- importing raw materials = increased costs
- shifts the AS curve inwards (raising prices)
How does labour cause cost pull inflation?
- the wage-price spiral
- when there’s inflation, firms need to increase wages, prices rise since pay rises, so wage increase (cycle)
- also expectations (ppl expect a pay rise)
Causes of demand pull inflation
- increase in AD = increased prices (when AD rises faster than economy’s productive capacity)
- the closer you are to maximum capacity, the more demand for inflation
Why does increase in AD cause in demand pull inflation?
- increase AD = increase prices in the short run
- increase in AD may not increase prices if there is spare capacity in the economy
- how much AD increase price level depends on where you are on the LRAS curve
- if there is spare capacity then AD can increase without inflationary pressure
Cost push inflation short run AS curve
Cost push inflation long run AS curve
Demand pull inflation short run AS curve
Effects of inflation on consumers
- inflation might reduce their purchases on certain things (especially elderly who are on fixed income)
- Shoe leather costs
- psychological costs
Effects of inflation on consumers (shoe leather costs)
- If prices are stable, consumer & firms will have some knowledge of which suppliers charge less but with inflation they don’t know
- this leads to more shopping around
Effects of inflation on consumers (psychological costs)
- price increases are deeply unpopular, people feel that they are worse off
- Consumer confidence can decrease
Effects of inflation on firms:
- reduced investments
- hard to supply goods
- menu costs
- business confidence
Effects of inflation on firms (investments)
- firms may reduce their investments because they are less willing to take risks in an unstable macroeconomic climate
- AD = decreased economic growth
Effects of inflation on firms (supply goods)
- if inflation reduce purchases on certain good
- it makes it hard to supply goods since consumers might reduce their purchases
Effects of inflation on firms (menu costs)
- inflation means restaurants have to change menu prices/ calculate prices
Effects of inflation on firms (business confidence)
If consumer confidence is low (due to consumers bing concerned about the future), business confidence is also low = lower investments
Effects of inflation on workers
- redistributional costs
- inflation can redistribute income
- Those with fixed income will suffer (e.g pensioners with fixed pensions which aren’t adjusted for inflation)
- If prices double, real income will halve
- if workers fail to negotiate pay increases in line with inflation, they will suffer falls in real income
Effects of inflation on the government
- international competitiveness
- redistributional costs
Effects of inflation on the government (international competitiveness)
- Inflation means a balance of payment effect
- If inflation rises faster in the UK than other countries & the value of the pound doesn’t change on foreign currency markets
- exports are less competitive & imports are more competitive (=loss of jobs in the domestic economy & lower growth)
Effects of inflation on the government (redistributional costs)
- Taxes and govt may not change in line with inflation
- (e.g if the Chancellor fails to increase personal income tax allowance ‘tax free’ in line with inflation, the burden of tax will increase, transferring resources from the taxpayer to the govt)
- (or if they fill in increase excise duties on alcohol in line, real govt revenue will fall whilst drinkers will be better off , since incomes have risen with inflation)
What causes increase inflationary pressures?
- the growth of money supply
- individuals and firm may spend their excess money on goods/services = increase AD
- increase demand for labour = increase demand for goods = rise in wages = rise in costs of production
How does hyperinflation occur?
Decreased tax revenue (due to war/change in commodity price/bad memory policies) = govt print money = increased money supply = increased inflation = periods of high inflation = decreased govt budget & confidence = more printing = increased inflation = currency collapses
Evaluation of effects of inflation
- effects of high inflation may depends on whether high inflation is temporary or persistent
- depends on inflation relative to competitors (use numerical example)
- whether nominal interest rates on savings & loans keep pace with inflation
Why is inflation hard to forecast?
- volatile global energy prices
- govt indirect taxes can change
- volatile food prices
- uncertain growth of AD
- changes in value of the currency
Volatile energy prices example
Causes of inflation
- Demand-pull inflation
- Cost-push inflation
- Devaluation
- Rising wages
- Expectations of inflation
Causes of inflation (devaluation)
increasing cost of imported goods, and also the boost to domestic demand.
Causes of inflation (rising wages)
higher wages increase firms costs and increase consumers’ disposable income to spend more
Causes of inflation (expectations of inflation)
High inflation expectations causes workers to demand wage increases and firms to push up prices.
Example of demand-pull inflation
In the 1980s, the UK experienced rapid economic growth
- the govt cut interest rates an tax
- house prices rose by up to 30%-causing a positive wealth effect and a rise in consumer confidence = higher spending, lower saving and increased borrowing
Explain the role of the IMF in providing financial assistance to countries such a
Why is controlling inflation important?
Low,stable inflation helps to promote macro stability – keeps domestic economy competitive and reduces business uncertainty
Why might QE not work?
Consumer/business confidence
