2.1.2 - inflation

Question 1

What is inflation?

Answer 1

A sustained increase in the general level of prices - average prices are rising

Question 2

What is deflation?

Answer 2

A sustained decrease in the GPL - average prices are falling

Question 3

What is disinflation?

Answer 3

A fall in the rate of inflation - average prices are increasing but at a slower rate

Question 4

What is hyperinflation?

Answer 4

A rate both unpredictable and sufficiently high enough to disrupt the functions of money

Question 5

What is the CPI?

Answer 5

The Consumer Price Index is the percentage change in a weighted average of a representative basket of goods and services.

Question 6

What is the basket of goods?

Answer 6

Hundreds of everyday items that the ONS keeps track of the prices of.
- weighted according to the proportion of income spent on particular categories
- the top 4% and pensioners are excluded to avoid statistical distortion
- items changed periodically to avoid statistical distortions

Question 7

What are the limitations of CPI?

Answer 7

• the CPI excludes many housing costs and may show lower inflation, less accurate
• the CPI includes all households - general measure
• doesn’t take into account changes in the quality of goods and services
• different consumption habits from households - not representative
• problems comparing over time due to change in the composition of the basket
• geographical differences and wage patterns
• statistical error
• substitution bias - XED
• shrinkflation

Question 8

What is an alternative measure of inflation to the CPI?

Answer 8

The RPI - retail prices index

Question 9

What does the government use RPI and CPI for?

Answer 9

The government uses RPI to calculate increases in funds they collect eg. rises in rail fares, duties on alcohol and tobacco, student loan repayments. It uses the CPI to work out increases in money they pay out eg. benefits, pensions, tax thresholds. This is because the RPI is around one percent higher than the CPI.

Question 10

What are the problems with RPI?

Answer 10

• the use of RPI added up to £16,000 to the cost of a student loan
• moves away from the RPI measure are costly and complex as it is used across public and private sectors

Question 11

Comparison of CPI to RPI

Answer 11

• excludes various housing costs (council tax)
• covers a broader section of society
• different mathematical formula means it is always lower than the RPI
• uses a geometric mean, arithmetic mean is used for the RPI

Question 12

What is demand-pull inflation?

Answer 12

As the economy verges towards full employment, scarcity of FOPs puts upward pressure on prices. Increase in GDP usually leads to an increase in the GPL.

Question 13

What do monetarists argue about demand-pull inflation?

Answer 13

They argue that increases in AD are caused by an expansion of the money supply rather than an automonus change in the components of AD. Cheaper borrowing costs stimulate credit fuelled consumption and investment by firms.

Question 14

What do non-monetarists suggest can lead to demand-pull inflation?

Answer 14

Increases in consumption and AD can be explained by cuts to income tax rates which increase disposable income. Also, higher investment may be the result of improved business confidence.

Question 15

What is cost-push inflation?

Answer 15

This results from a left shift in AS due to higher production costs. Firms increase prices to maintain profit margins. eg. increased unit labour costs, input costs, indirect taxes, depreciation of the currency.

Question 16

What are the effects of inflation on consumers?

Answer 16

• hard to predict the rate of inflation, impossible to plan for the future
• may reduce purchases, reduced consumer confidence, reduced utility
• exports may become less competitive so there is unemployment in the domestic economy
• pensioners receive fixed amounts not adjusted for inflation so their real incomes may fall
• consumers are less clear on what is a reasonable price, leads to more “shopping around” which is a cost
• households may have to spend more time transferring money from one account to another to maximise interest paid
• if the chancellor fails to increase excise duties on alcohol and tobacco in line with inflation, some consumers are better off in real terms
• reduced purchasing power
• bad for savers
• value of debt fall in real terms, good for borrowers
• positive wealth effect

Question 17

What are the effects of inflation on firms?

Answer 17

• difficult to plan for the future
• may reduce investment due to reduced business confidence and animal spirits
• exports may become less competitive - lower growth
• firms may hold less cash as opportunity cost of holding cash may be larger
• shops have to change price labels and calculate and issue new price lists (menu costs)
• there may have to be changes to fixed capital which is even more costly
• inelastic PED; increased price = increased total revenue
• firms that sell inferior goods experience increased consumption and profits

Question 18

What are the effects of inflation on workers?

Answer 18

• workers who fail to be able to negotiate pay increases will suffer from a fall in real income
• loss of jobs in the domestic economy due to decreased demand
• they may receive a wage increase causing them to be better off in real terms
• capital-labour substitution
• workers with bargaining power maintain real wages

Question 19

What are the effects of inflation on the government?

Answer 19

• if the chancellor fails to increase personal income tax allowances in line with inflation, the burden of tax will increase
• they may have to spend more on unemployment benefits
• if they increase wages in line with inflation, it is difficult to reduce inflation to a normal level again
• tax revenue decreases
• fiscal drag = higher wages