2.1.2 Inflation

Question 1

Define inflation

Answer 1

A sustained increase in the general price level/cost of living

Question 2

Define deflation

Answer 2

A sustained fall in the price level, occurring when the inflation rate is negative

Question 3

Define disinflation

Answer 3

Falling inflation, where the inflation rate falls but prices are still rising (at a slower rate)

Question 4

What is demand-pull inflation caused by?

Answer 4

An increase in aggregate demand (components), including government expenditure, investment and consumption

Question 5

Why does demand-pull inflation occur?

Answer 5

When there is increased demand in the market, producers can voluntarily increase the price levels of their goods/services to achieve higher revenue/profit

Question 6

What is cost-push inflation caused by?

Answer 6

An decrease in short-run aggregate supply, caused by an increase in costs of production (e.g. inc in wages/energy costs/VAT, weaker exchange rate)

Question 7

Why does cost-push inflation occur?

Answer 7

When production costs are rising, producers increase the prices of their products to maintain profit margins

Question 8

What is the Consumer Price Index (CPI)?

Answer 8

The CPI measures the rate of inflation by calculating the value of a basket of goods (around 700 items), representing the typical purchases of the average household. The CPI also has a weighted index to show the relative importance/value of each item within a households’ purchases/income.

Question 9

What are the limitations of the CPI? (4)

Answer 9

1. It is impossible to take into account every single good and service sold
2. Different households spend different amounts on each good (only measures an average)
3. CPI does not include the price of housing
4. CPI does not take into account how goods and services have improved in quality, which may the reason why they are more expensive (overestimated inflation)

Question 10

Differences between the CPI and the RPI (3)

Answer 10

1. The RPI includes housing costs (e.g. mortgage, interest payments, council tax)
2. RPI does not take into account that when prices rise, people may switch to another product that has gone up by less (CPI generally lower than RPI)
3. The RPI excludes the top 4% of income earners and low income pensioners (not part of the average)

Question 11

What is the quantity theory of money?

Answer 11

MV ≡ PY

Question 12

What does each element of the quantity theory of money represent?

Answer 12

M: money supply
V: velocity of money (how times it has been spent on finished goods/services)
P: price of finished goods/services
Y: real GDP (the value of finished goods/services sold)

Question 13

What does M x V represent?

Answer 13

Nominal GDP from what is bought (actions of buyers)

Question 14

What does P x Y represent?

Answer 14

Nominal GDP from what is sold (actions of sellers) - price level times real GDP

Question 15

What does the quantity theory of money state?

Answer 15

There is a direct relationship between the quantity of money (in an economy) and the price levels of goods and services

Question 16

How does inflation affect individuals? (5)

Answer 16

• workers are worse off/reduced real incomes: if wage growth is less than the inflation rate
• living costs may rise/living standards may falter: reduced value of money - can buy less with the same amount of money
• discourages saving and encourages borrowing: due to a reduced real value of interest rates
• fiscal drag: increased wages from inflation may cause them to have to pay (more) tax or lose social benefits, which could cause lower disposable income levels)
• shoe-leather/search costs: inflation causes individuals to spend more time searching for lower prices/better deals

Question 17

How does inflation effect firms? (5)

Answer 17

• less competitive with foreign competition: can lead to falling sales and profits
• rising costs of production
• less revenue/profit: due to higher prices of products from inflation (lower sales)
• higher business uncertainty/lower business confidence: not knowing what to expect in the future may deter firms from investing large amounts of money
• menu costs: firms may have to spend more money in changing prices on brochures, menus, labelling, etc.

Question 18

How does inflation affect the economy? (4)

Answer 18

• rising unemployment: due to rising costs of production or more imports
• widening the wealth gap: as those on fixed incomes face falls in real income
• the balance of payments deteriorating: inflation makes domestic goods less competitive and more expensive
• wage price spiral: workers continuously asking for wage increases to maintain their real income may cause firms to pass on higher prices

Question 19

What causes good/benign deflation?

Answer 19

Productivity improvements or competition (SRAS shifting outwards)

Question 20

What causes bad/malevolent deflation?

Answer 20

Low demand, which may have been the result of falling rGDP, a negative multiplier effect or cyclical unemployment, forcing businesses to drop prices to attract more consumers (AD shifting inwards)

Question 21

Consequences of deflation (4)

Answer 21

• discourages consumer spending/encourages saving: consumers may delay expenditure as they may expect prices to fall even more and real interest rates increase
• real wage unemployment: sticky wages
• discourages contracts/business investment due to uncertainty in the economy
• increased real value of debt as the real value of money increases: discourages borrowing