2.1.2 Inflation Flashcards
Inflation vs Deflation vs Disinflation
Inflation: the general increase of prices in the economy which erodes the purchasing power of money. Low inflation is generally considered to be better than high inflation.
Deflation: the fall of prices and indicates a slowdown in the rate of growth of output in the economy.
Disinflation: a reduction in the rate of inflation i.e. prices are still rising but they are not rising by as much.
Consumers Price Index CPI
The Consumer Price Index (CPI) is a measure of the average change overtime in the prices paid by urban consumers for a market basket of consumer goods and services.
Specifically, the CPI measures the average change in price over time of a market basket of consumer goods and services.
Limitations of Consumers Price Index CPI
● It is impossible for the figure to take into account every single good that is sold in the country and so therefore the CPI is not totally representative. Similarly, different households spend different amounts on each good and so therefore the CPI only measures an average rate of inflation, and is not totally representative.
● Moreover, 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.
● Since the figure is more recent than RPI, it is 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.
- Eval: Some people argue that all inflation indices overestimate inflation because they don’t take into account the fact that goods and services have improved in quality, and so will obviously be more expensive. For example, a car in the 1950s would be far less comfortable and reliable than today’s. It has no way of indicating the change of goods that is bought.
Retail Price Index RPI
The RPI is very similar to the CPI. However, there are some differences between the data included and the way it is calculated.
● RPI includes housing costs such as mortgage and interest payments and council tax, whereas CPI does not.
● CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.
● 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.
RPI is no longer considered as the best method and has had its national statistic status removed, although the Office for National Statistics still calculates it every month.
Causes of inflation
Demand pull
Cost push
Growth of money supply
Demand pull inflation
● Prices in a market are determined by demand and supply and a shift in either will cause price to change. Inflation can therefore be caused by an increase in aggregate demand (AD), total demand for goods and services in the economy.
● If any factor which increases AD was to increase (2.2), then inflation would increase
Cost push inflation
● Whilst an increase in aggregate demand can push prices up, a decrease in aggregate supply may also push prices up.
● When businesses find their costs have risen, they will put up prices to maintain their profit margins. This can be caused by any factor which decreases AS (2.3)
Growth of money supply inflation
● Another potential cause of inflation is there being too much money in the economy. If people have access to money they will want to spend it but if there is no increase in the amount of goods and services supplied, then prices will have to rise.
● The government can also increase the amount of money that they print and decisions to increase government borrowing can also increase the money supply.
Effect of inflation: on consumers
● Fall in living standards: If people’s incomes do not rise with inflation then they will have less to spend, which could cause 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
● Exchange rates (trade): 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.
● If deflation, people save rather than borrow: Deflation isn’t good as it 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.
● Difficult to predict: In general, inflation/deflation/disinflation is difficult to predict and so this means that firms cannot plan for the future.
● Menu costs: Another effect of changing prices is that firms will have to calculate new prices then change their menus, labelling etc. and this can be expensive.
Effects of inflation: on governments
● If the government fails to change excise taxes (taxes at a set amount e.g. £1) 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 workers
● Decrease in living standards: If workers do not receive yearly pay rises of the rate of inflation, they will be worse off and their living standard will decrease. Those in weaker unions tend to be most affected as they are unable to win wage rises in line with inflation.
● Unemployment: 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 evaluation
Some of these costs can be reduced if inflation is anticipated, which will allow groups to plan for the future. This can be done through indexation, so 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.
However, indexation may in itself further inflation because wage increases will reflect past increases. Therefore, if inflation has been at 10% previously but the government wants to reduce it to 2%, this will be difficult if workers are still getting a 10% pay rise due to indexation agreements.
Inflation synoptic point *
The effect on individuals (firms, consumers, workers) are microeconomic impacts whilst the inflation figure itself is a macroeconomic concept. This shows how the macro-economy has microeconomic effects.
