2.1.2 Inflation

Question 1

What is inflation?

Answer 1

Inflation is the sustained increase in the average price level of goods/services in an economy.

Question 2

How is the average price level measured?

Answer 2

The average price level is measured by checking the prices of a ‘basket’ of goods/services that an average household will purchase each month. This basket is then turned into an index and called the consumer price index (CPI).

Question 3

What is the UK inflation target?

Answer 3

The UK has an inflation target of 2% per annum. Low inflation is better than no inflation as it is a sign of economic growth.

Question 4

What is deflation?

Answer 4

Deflation occurs when there is a fall in the average price level of goods/services in an economy. Deflation only occurs when the percentage change in prices falls below zero %.

Question 5

What is disinflation?

Answer 5

Disinflation occurs when the average price level is still rising, but at a lower rate than before.

Question 5

How is the inflation rate calculated?

Answer 5

The inflation rate is calculated using an index with 100 as the base year. If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%.

Question 6

What 2 inflation indices does the UK use?

Answer 6

/Consumer price index (CPI)
/Retail price index (RPI)

Question 7

How much is a household basket in the CPI?

Answer 7

A ‘household basket’ of 700 goods/services that an average family would purchase is compiled on an annual basis.

Question 8

How is the items in the basket determined?

Answer 8

A household expenditure survey is conducted to determine what goes into the basket.

Question 9

How does weighting work in the CPI basket?

Answer 9

Goods/services in the basket are weighted based on the proportion of household spending. For example More money is spent on food than shoes, so shoes have a lower weight in the basket.

Question 10

How is the final values for the goods/services in the basket determined?

Answer 10

The price x the weighting determines the final value of the good/service in the basket. These final values are added together to determine the price of the ‘basket’.

Question 11

How is CPI calculated?

Answer 11

Cost of basket in year X
———————————————- x 100
Cost of basket in base year (100)

Question 12

How is the inflation rate gathered from the CPI?

Answer 12

The percentage difference in CPI between the two years is the inflation rate for the period.

Question 13

What are the limitations for using CPI?

Answer 13

/Average basket
/One of several methods
/Quality of products
/Index is always behind
/Errors in data collection

Question 14

Explain how average basket is a limitation of CPI?

Answer 14

The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket.

Question 15

Explain how one of several methods is a limitation of CPI?

Answer 15

The CPI is one of several methods used by countries in determining inflation - another is the retail price index (RPI). This can make comparisons between countries less meaningful as one may use the RPI & another the CPI.

Question 16

Explain how quality of products is a limitation of CPI?

Answer 16

The CPI does not capture the quality of the products in the basket. Product quality changes over time and so the comparison with different time periods is less useful.

Question 17

Explain how index is always behind is a limitation of CPI?

Answer 17

The CPI only measures changes in consumption on an annual basis. Changes in consumption can occur more frequently and the index is always behind these changes.

Question 18

Explain how errors in data collection is a limitation of CPI?

Answer 18

The CPI is prone to errors in data collection. It is based on a survey that goes to thousands of households each year, yet it is still a small sample. The respondents have no incentive to fill in the survey carefully and accurately.

Question 19

What is the retail price index (RPI)?

Answer 19

The retail price index (RPI) is calculated in exactly the same way as the CPI. Certain goods/services that are excluded from the CPI are included with the RPI. These include council tax, mortgage interest payments, house depreciation, and other house purchasing costs such as estate agents fees.

Question 20

Is RPI or CPI usually higher?

Answer 20

Due to the extra inclusions, inflation measured using the RPI is usually higher than the CPI. This is mainly due to its sensitivity to interest rate changes which affect mortgage interest. It’s argued that the RPI is a more accurate indication of a households inflation.

Question 21

What are the causes to inflation?

Answer 21

/Demand pull inflation
/Cost push inflation
/Changes to wages
/Changes to the money supply

Question 22

Explain demand pull inflation?

Answer 22

Demand pull inflation is caused by excess demand in the economy. Demand curve is shifted to the right pushing prices higher.

Question 23

Explain cost push inflation?

Answer 23

Cost push inflation is caused by increases in the costs of production in an economy. Supply curve is shifted to the left which causes prices to increase.

Question 24

Explain how changes to wages causes inflation?

Answer 24

Workers may demand wage increases to compensate for the higher prices. Those wage increases are now a form of cost push inflation (increased costs of production) and drive prices even higher. This economic phenomenon is called a wage-price spiral.

Question 25

Explain how changes to the money supply causes inflation?

Answer 25

If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers. This will result in an increase in consumption and investment. It is likely to lead to a form of demand-pull inflation.

Question 26

What is a second way changes to money supply causes inflation?

Answer 26

The Central Bank can also increase the money supply through quantitative easing. This will result in increased liquidity and lower interest rates. It is likely to lead to a form of demand-pull inflation.

Question 27

Impacts of inflation on firms?

Answer 27

Uncertainty: Rapid price changes create uncertainty and delay investment. Menu change costs: Price changes force firms to change their menu prices too and this can be expensive.

Question 28

Impacts of inflation on consumers?

Answer 28

Decrease in purchasing power. Decrease in the real value of savings (as money will be worth less in real terms). Fall in real income for those on fixed incomes/pension.

Question 29

Impacts of inflation on governments?

Answer 29

Inflation erodes international competitiveness of export industries. Trade-offs involved in tackling inflation for example reducing inflation may increase unemployment and/or reduce economic growth.

Question 30

Impacts of inflation of workers?

Answer 30

Demand higher wages to compensate for reduced purchasing power. If wage increases ≠ inflation, motivation & productivity may fall.