2.1.2 - Inflation Flashcards
What is Inflation
The sustained increase in the general price level of goods/services in an economy over time.
- It erodes the purchasing power of money.
What is deflation
The decrease in the general price level over time.
- It increase the purchasing power of money.
What is Disinflation
A decrease in the rate of inflation (the general price level is increasing, but at a slower rate than before) e.g. inflation falls from 5% to 4%.
How do we calculate g the rate of inflation in the UK
using the Consumer Prices Index (CPI) ?
What are the limitations of CPI in measuring the rate of inflation ?
● 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. This can result in the inflation rate being either undervalued or overvalued. This can be a major problem, especially when considering policy decisions can be made based upon the inflation rate of the economy.
● 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.
● Different measurements of inflation are used by different countries – Other countries may use different inflation measurements such asRPI. For example, CPI is often less than RPI as it doesn’t include housing costs and therefore this can make comparisons between countries using different inflation measurements difficult to make.
Blurt everything you know about RPI
- The retail price index (RPI) is calculated in exactly the same way as the CPI.
Demand pull inflation
Diagram Analysis
If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD1 → AD2.
- This will cause and increase in the PL from P1 to P2, meaning there is inflation in the economy as a result of the increase in demand.
there is also contraction an extension of SRAS.
Cost push inflation
Could be due to :
- an increase in any of the factors of production.
- Fall in productivity
- Higher interest rates = cost of debts increase.
- decrease in the value of the UK currency will result in imports becoming more expensive
firms have to raise price to maintain their profit margin.
Blurt everything you know about the growth of money supply.
- Too much money in the economy can lead to inflation as if the money supply grows too big relative to the size of an economy, the unit value of the currency diminishes; in other words, its purchasing power falls and prices rise.
- ‘Too much money chasing too few goods’
How does the wage spiral lead to inflation ?
- When inflation happens
- Workers now feel less well off as their wages no longer have the same purchasing power.
- Workers may demand wage increases to compensate for the higher prices.
- Those wage increases are now a firm of cost push inflation (increased costs of production) and drive prices even higher.
Effects of inflation on consumers.
● Consumers :
- Fall I’m PP means that their weekly spending will not buy the same quantity of goods/services as it used to.
- Fall in living standard of living as they wont be able to afford the same basket of goods so they have to cut down on items e.g private health care.
- Shoe leather costs as they will have to spend more time looking for cheaper goods elsewhere.
Effects of inflation on firms
- international price competitiveness -
- When inflation in a country, such as Britain, is higher than in other countries, the country’s goods and services become more expensive relative to foreign goods. This leads to a loss of competitiveness in international markets, making it harder to export goods. As a result:
- Exports decrease due to higher prices, as foreign buyers may seek cheaper alternatives from other countries.
- Imports increase because domestic consumers may prefer cheaper foreign goods, worsening the balance of payments.
This phenomenon directly affects a country’s current account within the balance of payments. The current account deficit may widen as the value of imports exceeds the value of exports, reflecting a negative impact on trade.
One benefit of inflation on consumers
One benefit is that the real value of debt/loan repayments will decrease. As, loan repayments do not align with inflation the consumer will experience this benefit, leaving consumers with more disposable income to spend, thus increasing consumption.
- Reduced debt can reduce inequality
Effects of inflation on government
- ## Earn less tax rev(from income and cooperation tax) but have to spend more on benefits.
Effects of inflation on workers
- Wage spiral
- Affects their living standards
- Unable to pay their trade unions (some)
- may loose jobs
Examples of when the deflationary spiral happened in real life.
The Great Depression - 1929
- 25% of GDP was lost
- As the stock market crashed and banks failed, people lost their savings and became highly cautious with spending.
- This drop in demand led to falling prices.
Businesses responded by cutting production, leading to mass layoffs and wage cuts. With less income, consumer demand further decreased, deepening the deflation. - What Happened?:
As the stock market crashed and banks failed, people lost their savings and became highly cautious with spending. This drop in demand led to falling prices.
Businesses responded by cutting production, leading to mass layoffs and wage cuts. With less income, consumer demand further decreased, deepening the deflation.
The vicious cycle continued as lower demand caused more price drops and more economic contraction.The vicious cycle continued as lower demand caused more price drops and more economic contraction.
