2.1.2 Inflation Flashcards
Inflation
Inflation is a sustained rise in an economy’s general price level . This means that , on average , the prices of goods and services are going up over time . It can also be described as the sustained increase in the cost of living / fall in the purchasing power of money .
How does inflation erode the value of money?
Over time , the price of goods and services tends to rise . If wages and earnings remain constant , then as prices rise , consumers are worse off in real terms , as their disposable income will buy less goods and services than previously . Therefore , it is said that inflation erodes the value of money .
UK target inflation rate
Inflation is a main focus of macroeconomic policy and the Bank of England has been delegated an inflation target of 2% .
Hyper - inflation
a phase of extremely rapid inflation nearly always the result of mass money printing by the government with money as an asset ending up as worthless . It is also associated with economies where there has been a collapse in real output / supply .
Deflation
a sustained period when the general price level for goods and services is falling . This means that a weighted basket of goods and services is becoming less expensive over time . The annual rate of inflation is negative .
Disinflation
a fall in the rate of inflation but not sufficient to bring about price deflation . During a period of disinflation consumer prices are still rising but at a slower rate , for example a drop in the annual inflation rate from 7 % to 2 % .
Inflation expectations
describes what people and businesses expect to happen to consumer prices in the future ( usually one year ahead ) . Once a high rate of inflation becomes established it can be difficult to remove . If people expect higher prices , this can then feed through to higher wage claims and rising costs . This is known as a wage - price spiral .
Stagflation
refers to an unfortunate and costly combination of stagnant ( slow ) economic growth , rising unemployment and high and rising inflation .
What two ways can we measure inflation?
- The Consumer Prices Index ( CPI ) or CPIH
- The Retail Prices Index ( RPI ) The preferred measure is the CPI , and this is the measure that forms the Bank of England Target . Both indexes are “ weighted “
The cost of living
a measure of changes in the average cost of buying a basket of different goods and services for a typical household . Inflation is the rate of change in the cost of living .
Consumer Price Index ( CPI )
A Consumer Price Index (CPI) tracks changes in the average price level of a basket of goods and services purchased by households over time. It’s a widely used economic indicator for assessing inflation and cost-of-living adjustments. CPI compares current prices to base year prices, with weights based on household spending patterns. In the UK, housing and household services account for 30% of inflation, while food and non-alcoholic drinks account for less than 10%. Weights are periodically adjusted to reflect changing spending patterns.
CPIH
In 2013 a new measure , called CPIH , was introduced . CPIH includes the housing costs of owner - occupiers . This index is now published alongside CPI .
The basket of goods and services
- The Office of National Statistics ( ONS ) compile the CPI and RPI
- Both measures are based upon a basket of goods and services which is designed to represent typical purchases of consumers throughout the UK
- The Office for National Statistics ( ONS ) collects prices on 710 goods and services from 20,000 shops in 141 locations and online sites and the prices are updated every month , with collectors visiting the same retailers to monitor identical goods .
- Different items are weighted according to their relative importance in terms of how much their price changes impact upon consumers.
- The ONS collect a total of 180,000 individual prices on products each month .
- Data from the Household Final Monetary Consumption Expenditure survey is used to compile the weightings .
Limitations of CPI
- The CPI basket isn’t fully representative of all consumers. For instance, 10% of the CPI index covers motoring costs, which is inapplicable to non-car owners. Single people spend differently from those with children.
- Data errors, such as sampling errors from surveys, also contribute to inaccuracies.
- Many digital economy services, like Google searches, WhatsApp, and Instagram feeds, don’t have prices.
- Additionally, the quality of goods and services can change without easily reflecting in prices.
- Lastly, the CPI is slow to respond to new products in markets, with only minor changes to the CPI basket each year.
RPI
RPI includes housing costs (mortgage interest and council tax), while CPI doesn’t.
Cost - push inflation
occurs when businesses respond to rising unit costs by increasing prices to protect their profit margins . Cost push inflation can come about from both domestic and external sources including a fall in the external value of the exchange rate which then leads to a rise in prices of imported products .
What are some causes of cost-push inflation?
- Rising labour costs perhaps due to an increased minimum wage
- Higher global prices for components and raw materials including imported energy ( oil and gas ) and foodstuffs
- A depreciation in the external value of the exchange rate which then causes a rise in import prices - many imports are priced in US dollars
- An increase in indirect taxes such as higher VAT or environmental taxes such as a carbon tax
Demand - pull inflation
a phase of accelerating inflation which arises from a rapid growth in aggregate demand . It occurs when economic growth is too fast . Businesses can take advantage of high demand by raising their prices to widen (increase) profit margins . Typically , demand - pull inflation is associated with an economic boom .
What are some causes of demand-pull inflation?
- Demand pull inflation happens when the economy is growing too quickly , and aggregate demand for goods and services outstrips supply.
- When this happens , prices for everything start to rise , because consumers are willing to pay more to get the things they want.
- This can be caused by several things , including economic growth , low interest rates , and an increase in the money supply.
- If the government engages in excessive fiscal stimulus , like cutting taxes or increasing spending , it can boost demand and lead to inflation . This kind of inflation is often seen as a sign that the economy is “ overheating “ and that corrective measures need to be taken.
How does the growth of money supply lead to inflation?
- As the money supply increases, individuals and businesses have more to spend. If the supply of goods and services doesn’t increase or decreases at the same rate, demand can exceed supply.
- When demand exceeds supply, sellers can raise prices to capture more money.
- Expectations of future inflation can worsen the problem. People may buy sooner to avoid rising prices, fueling demand and price increases.
- Rising prices can lead to higher wages as workers seek to maintain real purchasing power.
The growth of money supply’s link to the fisher equation
This idea grew out of the fisher equation : MV = PT where M is money supply , V is speed of money circulating in the economy , P is the price level and T is the number of transactions . An increase in money supply will lead to an increase in price level , ceteris paribus .
How can money supply be increased?
- The money supply can be increased by banks creating credit (known as the bank multiplier) .
- Banks make their money by taking in our deposits and then lending money out at interest rates .
- The person who receives the money the borrower has spent is likely to input it back into the banking system where the bank sees it as a new deposit and a percentage of this deposit is then lent out . For example , the initial bank deposit is £ 100m and they keep £ 10m then lend out £ 90m so the deposit is then £ 90m , £ 9m is kept and £ 81m is lent out so the deposit is £ 81m , they keep £ 8.1m and £ 72.9m is lent and so on . In this way , the banks increase the money supply .
Milton Friedman
Milton Friedman was one of the most influential economists of the 20th century , and he was a leading advocate of monetarism . He was an American economist and statistician who taught at the University of Chicago for many years . In 1976 , he won the Nobel Prize in Economics for his work on consumption analysis , monetary history , and the relationships between inflation and unemployment . He’s well known for his strong support of free - market policies and opposition to government intervention in the economy . His ideas were hugely influential during the 1980s and 90s .
Monetarism
Monetarism suggests that the amount of money in an economy plays a crucial role in determining the overall price level , or inflation . If the central bank increases the money supply too rapidly , it can lead to inflation because there is “ too much money chasing too few goods . “
What are monetarists critical of?
Monetarists are often critical of using fiscal policy ( government spending and taxation ) to manage the economy . They argue that fiscal policies can be unpredictable and lead to economic instability .
What concept do monetarists believe in?
Monetarists believe in the concept of long - run neutrality of money . This means that in the long term , changes in the money supply do not affect real variables like employment and output but primarily impact nominal variables like prices .
Causes of the surge in UK inflation in 2022-23
Pandemic - related supply shortages: As the world economy recovered from the pandemic , demand for supplies and materials increased , but the supply couldn’t keep up . This led to higher prices for raw materials and products , which pushed up inflation .
Conflict in Ukraine: The conflict has caused a spike in energy prices , as Russia is a major exporter of natural gas and other fuels . Higher energy prices have pushed up the cost of production for many businesses .
Labour shortages: These have been a big problem in the UK , especially in sectors , like healthcare and logistics . A lack of workers has made it difficult for businesses to operate , and it’s pushed up wages for those workers who are available .
Price gouging
Price gouging refers to the practice of charging excessive or unreasonable prices for goods or services in response to a situation of increased demand or limited supply , such as during a natural disaster , pandemic , or other emergency . In such situations , demand for certain goods or services may increase dramatically , and the supply may be constrained , leading to scarcity and higher prices .
What is price gouging also known as?
Greedflation
When does price gouging occur?
Price gouging occurs when sellers take advantage of a situation (like a pandemic or natural disaster) by charging prices that are much higher than what would be considered reasonable under normal market conditions .
Shrinkflation
Shrinklation refers to the practice of companies reducing the size or quantity of a product , while keeping the price the same or even raising it .
What does shrinkflation allow?
This allows companies to keep prices stable or even increase them , without consumers noticing as much . It’s a form of “ hidden inflation “ that can be difficult to detect
Effects of inflation on consumers
If people’s incomes do not rise with inflation then they will have less to spend , which could cause a fall in living standards . Those who are in debt will be able to pay it off at a price which is of cheaper value , but those who are owed money lose because the money they get back is of cheaper value . Consumers who have saved will lose out as their money is worth less . Inflation has psychological effects on consumers : because prices are rising , they may feel less well - off , even if their income is rising in line with inflation , and so this may cause them to decrease their spending .
Effects of inflation on firms
- If inflation in Britain exceeds that of other countries, British goods become more expensive, reducing competitiveness and making exports harder, which impacts the balance of payments.
- Deflation is also problematic as it encourages delayed purchases, increased saving, and reduced borrowing due to rising real debt values. This lowers demand, erodes profits, weakens business confidence, and discourages long-term investment.
- Unpredictable inflation, deflation, or disinflation complicates planning for firms, while price changes impose costs for updating menus, labels, and systems.
Effects of inflation on government
If the government fails to change excise taxes ( taxes at a set amount e.g. £ 1 ) in line with inflation then real government revenue will fall . However , if they fail to change personal income tax allowances ( the amount a worker can earn tax free ) then real government income will increase and taxpayers will have less money .
Effects of inflation on workers
If workers do not receive yearly pay rises of the rate of inflation , they will be worse off and their living standard will decrease . Those in weaker unions tend to be most affected as they are unable to win wage rises in line with inflation . Deflation could cause some staff to lose their jobs as there is a lack of demand meaning firms see a fall in profit and have to decrease staff to cut costs .
Indexation
Indexation is when wages or taxes are increased in line with inflation . An example of this is workers negotiating with employers for wage rises in line with the predicted CPI or RPI . However , indexation may in itself further inflation because wage increases will reflect past increases . Therefore , if inflation has been at 10 % previously but the government wants to reduce it to 2 % , this will be difficult if workers are still getting a 10 % pay rise due to indexation agreements, increasing costs for firms, which in turn increases prices.
Policies to control Demand pull inflation
- Increases in interest rates and a tightening of the supply of credit
- Contractionary fiscal policy - higher taxes and cuts in state spending
Policies to control Cost - push inflation
- Supply - side policies to increase productivity
- Labour market reforms to increase labour supply
Supply Side Policies to reduce cost-push inflation
- Expansion of the worker - visa programme to encourage more skilled workers into the UK from the EU and beyond
- Policies to encourage increased house - building to address chronic shortages and rent inflation
- Investment in human capital to improve labour productivity and lower unit labour costs
- Investment tax allowances to drive investment in and scale of renewable energy and gas storage
- Infrastructure investment to help lower business costs in the long run ( improved transport networks , telecoms )
Reasons why inflation is hard to control
Global Economic Factors : Fluctuations in global commodity prices , exchange rates , and international trade can affect the cost of imports and , consequently , domestic prices .
Supply - Side Shocks : Supply - side factors , such as natural disasters , geopolitical conflicts , or supply chain disruptions , can lead to sudden and unexpected increases in production costs .
Built - In Inflation : In countries with a history of high inflation , there may be built - in inflationary expectations . Workers may demand higher wages to keep up with expected price increases , and businesses may increase prices in anticipation of rising costs . This wage - price spiral can be self reinforcing and challenging to break .
Monetary Policy Lag : The impact of higher interest rates , may not be felt immediately . There can be a lag between the time a policy change is implemented and when it affects the economy . Household spending may be resistant to changes in interest rates .
Compare CPI and RPI
- RPI was introduced in 1947, while CPI came in 2003.
- CPI is easier to compare with other European countries because it uses the same methodology.
- CPI considers price changes and encourages consumers to switch to less expensive products, resulting in lower CPI values.
- RPI excludes the top 4% of income earners and low-income pensioners, while CPI covers all households and incomes.
- RPI is no longer considered the best method but is still calculated monthly by the Office for National Statistics.
