2.1.2 Inflation Flashcards
Inflation
The sustained rise in the average price level of goods or services in an economy.
This causes a fall in the value (purchasing power) of money.
Inflation causes a fall in the value of money. What does this mean?
- A fixed amount of money buys less than before.
- The purchasing power of money has fallen.
Inflation
When the average price of goods and services is rising.
Deflation
When the average price of goods and services is falling.
Disinflation
When the rate of inflation is slowing down – prices are still rising, but at a lower speed.
Hyperinflation
When prices rise extremely quickly and money rapidly loses value.
What are the two measurements of inflation?
- RPI
- CPI
Retail Price Index (RPI)
An older measurement of inflation and is used to calculate the cost of living. However, it is not considered to be an official inflation rate by the government. RPI has largely been replaced by the CPI.
How is RPI calculated?
A survey called the Living Costs and Food Survey is done, including around 6000 households, to find out what people spend their money on. This survey also shows what proportion of income is spent on these items. This is used to work out the relative weighting for each item. | E.g. If 20% of income is spent on transport, then a 20% weighting will be given to transport.
RPI is calculated based on the changes in price of around 700 of the most commonly used goods/services (referred to as the ‘basket of goods’).
These items are chosen based on a living costs and food survey. What is in the basket changes over time, because technology, trends and tastes change – which ensures the basket always reflects what the average household might spend its money on.
The price changes are multiplied by the weighting given to it (based on the proportion of income spent on these items). The price change is then converted to an index number, so inflation is the percentage change of the index number over time. E.g. if the index number rises from 100 to 201, then inflation is 2%.
How is Consumer Price Index (CPI) calculated?
CPI is calculated in a similar way to RPI, but with three key differences:
1) Some items are excluded from the CPI, the main ones being:
- Housing costs
- Council tax
2) A slightly different formula is used to calculate the CPI.
3) A larger sample of the population is used for the CPI.
Differences between RPI and CPI
The differences mean that the CPI tends to be lower than the RPI – with the exception of when interest rates are low. However, they both tend to follow the same long-term trend.
The CPI is the official measure of inflation in the UK. Many other countries collect data on inflation in a similar way to CPI so it is often used for international comparisons.
Limitations of RPI and CPI
The RPI and CPI can be really useful, but they also have their limitations:
1) The RPI excludes all households in the top 4% of income. The CPI covers a broader range of the population but doesn’t include mortgage interest payments or council tax.
2) The information given by households in the Living Costs and Food Survey can be inaccurate.
3) The basket of goods only changes once a year – so it might miss out short-term changes in spending habits.
How are CPI and RPI used to measure changes in the UK’s international competitiveness?
- If the rate of inflation measured by the CPI is higher in the UK than in the other countries it trades with, then UK goods become less price competitive as they’ll cost more for other countries to buy.
- So exports will fall, and imports will increase (as they are made cheaper by domestic inflation).
How are CPI and RPI used to help to determine wages and state benefits?
- Employers and trade unions use them as a starting point in wage negotiations.
- The government uses them to decide on increases in state pensions, and other welfare benefits.
- Some benefits are index-linked and will rise automatically each year by the same percentage as the chosen index.
Two types of inflation:
- Demand-pull inflation
- Cost-push inflation
How does demand-pull inflation change the supply/demand curve?
This growth in demand shifts the AD curve to the right (AD to AD1), which allows sellers to raise prices.
How does cost-push inflation change the supply/demand curve?
Rising costs of inputs to production force producers to pass on the higher costs to consumers in the form of higher prices, which causes the aggregate supply curve to shift to the left (from AS to AS1).
