2.1.2 - inflation Flashcards
What is inflation?
A sustained increase in the general price level of goods and services in an economy in a given period of time - decreasing purchasing power of money
What is deflation?
A sustained decrease in the general price level of goods and services in an economy in a given period of time - increasing the purchasing power of money and decreasing costs of production
What are deflationary spirals?
- Discourages spending and investment as people expect prices to go down more, reducing consumer and business confidence; also increases value of debt
- Central banks cut interest rates to raise general price level, but can’t lower interest rates below zero as individuals achieve zero interest by keeping money in their pockets, so hard to escape deflationary spirals when AD is decreasing
What is disinflation?
A fall in the rate of inflation, where prices are still rising but at a slower rate, stabilizing the economy and usually caused by tightening monetary policy
What is hyperinflation?
When a country experiences very high and acceleratory inflation
What does the Consumer Price Index (CPI) measure?
The Consumer Price Index (CPI) measures the average change in prices over time that consumers pay for a basket of goods and services.
What is the method to calculate CPI?
- Living Costs and Food Survey asks 7000 respondent per year about their spending habits
- Sets a ‘basket’ of 650 goods and services which have higher share of expenditure
- Each item is weighted to reflect is share of total household expenditure
- Data on prices collected monthly through a Price Survey
- Weighted average price for basket calculated
- Weighted average price adjusted to an index figure compared to base year
- Percentage change from present month in base year to present month in present year calculated, which is the rate of inflation
What are the limitations of CPI?
- Assumes constant consumption patterns
- Doesn’t account for changes in quality
- Doesn’t reflect subgroups of population
- Doesn’t include housing costs
- Difficult to make comparisons with historical data as more recent than RPI, as well as international comparisons as they may not be accurate if countries don’t calculate in the same way
What does the Retail Price Index (RPI) measure?
Includes a broader range of expenditures than CPI. It is used for various purposes, including index-linked bonds and some pension calculations.
- It tends to be a higher rate than CPI
- Includes housing costs, such as mortgage interest, house depreciation, and council tax
- Doesn’t take into account the fact when prices rise people will switch to cheaper alternatives
- Excludes the top 4% of income earners and low income pensioners as they aren’t ‘average’ households, whereas CPI covers all households and incomes
When does demand-pull inflation occur?
Demand-pull inflation occurs when general price level increase due to an outward shift in AD, which in turn increases the output of the economy (real GDP). This puts pressure on existing factors of production to produce more output getting closer to YFE, increasing price of capital due to more competition of scarce resources which are passed onto the price of goods of services.
When does cost-push inflation occur?
Cost-push inflation occurs when general price level increases due to an inward shift in AS as costs of production has increased for firms, which in turn decreases the output of the economy (real GDP). The increased costs of production are passed onto the price of goods and services.
How does the growth of money supply cause inflation?
Individuals will have a higher real purchasing power but if no increase in amount of goods and services supplied, general price level has to increase. Government borrowing and actions to support it can lead to an increase in the money supply as they can issue bonds to the central bank, whom can buy them by creating new money to do so, which increases the total amount of money in the economy.
What are the consequences of high inflation?
- Erodes value of savings assuming interest rates don’t rise/fixed income
- Real value of debt falls
- Fall in exports as goods less internationally competitive
- Decreased consumer and business confidence as rising uncertainty
- Shoe leather costs – individuals spend more time searching for cheaper , alternatives to save money, opportunity cost of working and earning income instead
- Menu costs – businesses have to keep updating prices on menus, increasing administrative costs
- Income distribution issues
- Distorted price mechanism – businesses and consumers unable to act rationally , especially if rate of inflation constantly fluctuates
- Changes in taxes in line with inflation, changes in GOV spending
- Fiscal drag - tax brackets don’t rise with inflation, rising incomes in line with inflation means consumers get dragged into higher tax brackets, reducing standard of living
- A wage-price spiral, where issues arise if don’t rise in line with inflation
What are the benefits of a low, stable rate of inflation?
- Higher nominal wages can encourage productivity as it boosts morale, and can keep unemployment low if the increase in wages is slightly lower than the rate of inflation
- Firms don’t have to cut nominal wages if disinflation as price mechanism lowers real value, unnoticeable reduced purchasing power due to a slight increase in general price level means workers won’t demand higher wages and no drastic increase in costs of production
- No changes in consumer behavior
- Firms encouraged to increase output to generate more revenue
- Increase in government revenue
- Increased consumer and business confidence
What is a wage-price spiral?
- Wage-price spiral as workers might ask for higher wages so can afford goods and services, causing an outward shift in AD and raising general price level
- Higher wages raises general price level further as cost of production increases, causing an inward shift in SRAS which initiates cost-push inflation
- This starts a cycle where prices and wages simultaneously rise
- Wage-price spiral less likely to occur if consumers act rationally and increase consumption now in anticipation of prices rising, however can cause demand-pull inflation
What are the advantages of using index numbers in economic comparisons?
*Simplifies comparisons of numbers over time
*Removes the effect of differently sized datasets when comparing
What are index numbers used for in economics?
Index numbers are used by economists when making comparisons over time. It is a figure/statistic that reflects a price or quantity compared with a ‘base value/year’
What does the base value of an index number represent?
The base value always has an index number of 100.
How is an index number expressed?
The index number is expressed as 100 times the ratio to the base value, index number = (raw number)/(base year raw number)*100
What are the unintended consequences of deflationary spirals
- More money stored outside the banking system which decreases economic activity
- Discourage lending by banks as risk of loosing money and can lead to a liquidity crisis as many withdraw due to negative interest rates
