2.1.2 Inflation Flashcards
What is inflation?
It is the general increase in prices of goods in an economy overtime which arose the purchasing power of money.
What is deflation?
it is the decrease in the general price level of gain services in an economy over a period of time.
What is disinflation?
It is the reduction in the rate of inflation, meaning that prices are still rising, but at a slower pace.
What is the consumer price index (CPI) ?
It is a measure that examines the average change over time in the prices paid by consumers for a basket of goods and services.
-It is one of the most widely used indicators for inflation and reflects the cost of living.
how is the rate of inflation measured using CPI?
It uses the idea of a “basket of goods,” which is weighted according to consumption to reflect the spending habits of an average household. This basket contains approximately 700 items, and it changes over time to adapt to evolving spending patterns. Data for the CPI is gathered through a Family Expenditure Survey, and the index is calculated against a base year to provide a clear measure of price changes.
-To calculate the inflation rate,
[CPI in Current Period - CPI in Previous Period) / CPI in Previous Period] x 100.
What are the limitations of using CPI and measuring the rate of inflation?
It can’t account for every good sold in the country, making it less representative. It also excludes housing costs, which are significant expenses. The list of 700 goods is updated only once a year, so it may not capture sudden changes in spending. Additionally, there are issues with sampling, as some households may not provide accurate information or respond to the survey.
Retail Price Index of Inflation
It’s similar to the Consumer Price Index but is not as reliable.
RPI includes housing costs, such as mortgage and interest payments and council tax, which CPI does not.
CPI accounts for consumer behavior, noting that when prices rise, people tend to switch to products that have increased in price by less, leading to generally lower CPI values compared to RPI. Furthermore, RPI excludes the top 4% of income earners and low-income pensioners, as they are not considered “average” households, while CPI includes all households and income levels.
What are the 3 causes of inflation?
1) Demand-pull inflation =
Occurs when aggregate demand (total demand) in the economy increases at a faster rate than aggregate supply.
2) Cost-push inflation =
Occurs when aggregate supply decreases, i.e. the total costs of production increase.
3) Growth of money supply =
Some economists (monetarists) argue that the sole cause of inflation is increases in the money supply.
What are the causes of demand-pull inflation?
1) A decrease in interest rates
2) A rise in the level of business and consumer confidence.
3) An increase in government spending
4) Exports rising relative to imports
5) Depreciation of the exchange rate (increasing demand for exports and reducing demand for imports).
What are the causes of cost-push inflation?
1) A rise in oil prices and/or raw material prices.
2) A fall in the exchange rate (making imports more expensive).
3) A rise in taxes on businesses
4) An increase in the minimum wage or in wages generally.
5) Increased regulations, e.g. environmental regulations, health & safety, that increases costs.
How does inflation impact individuals?
1) Consumers:
- Each pound is worth less – less spending power
- Could be ‘regressive’ if higher inflation is driven by rising prices of necessities – food, fuel, housing.
2) Workers:
- Could lead to a fall in income in real terms
- Employees in poor bargaining positions tend to lose out.
3) Savers:
- Reduces the ‘real’ value of savings
4) Borrowers:
- Reduces the ‘real’ value of debt
How does inflation impact Firms/Businesses?
1) Increased ‘menu costs’ due to rapidly changing prices
2) Loss of competitiveness compared to foreign firms
3) Rising costs of materials and labour
4) Less investment due to lower confidence and more uncertainty
5)Higher prices could lead to greater revenues
How does inflation impact the government?
1) Value of ‘real’ debt falls – real value of national debt owed by governments might fall.
2) Having to deal with high inflation makes it more difficult for governments to achieve other objectives.
How does inflation impact the economy?
1) Objective of low inflation not met.
2) Lower investment, due to uncertainty, could lead to lower real output.
3) Loss of competitiveness of domestic firms worsens the current account.
4) Lower investment might mean fewer new jobs being created, so increasing unemployment.
How do you work out the index number?
(Raw number/ Base year number) x100
