2.1.2 Inflation (Edexcel)

Question 1

What is inflation?

Answer 1

Inflation is a sustained increase in the general price level (GPL). This leads to a fall in the real purchasing power of money i.e. a rise in the cost of living

Question 2

What is the UK inflation target?

Answer 2

The UK government has set an inflation target of 2% using the consumer prices index (CPI). The inflation target is not 0% - economic growth and rising employment are associated with low levels of demand- pull inflation, and so most governments want a little inflation.

Question 3

What is the BoE’s job?

Answer 3

It is the job of the Bank of England (BoE) to set monetary policy base interest rates so that inflationary pressures
are controlled, and the inflation target is reached over a two-year forecasting time period

Question 4

What is deflation?

Answer 4

Deflation is the opposite of inflation, characterized by a sustained decrease in the general price level.
It increases the purchasing power of money but can discourage spending and investment.

Question 5

What is disinflation?

Answer 5

Disinflation occurs when the rate of inflation declines but remains positive.
Prices are still rising, but at a slower rate than before.

Question 6

What is the Consumer Price Index (CPI)?

Answer 6

CPI is a widely used measure of inflation in the UK.
It tracks changes in the prices of a basket of goods and services purchased by an average household.

Question 7

Explain the limitations of CPI in measuring inflation

Answer 7

1. The CPI is not fully representative - it will be inaccurate for the ‘non-typical’ household, e.g. 14% of the CPI
   index is devoted to motoring costs - inapplicable for non-car owners.
2. Spending patterns: e.g. Single people have different spending patterns from households that have children
3. Changing quality of goods and services: Although the price of a good or service may rise, this may also be
   accompanied by improvements in quality / performance of the product, which cannot be taken into account
   by the CPI
4. New products: The CPI is slow to respond to new products and services – the CPI basket is changed each
   year but only a few items fall out or come in for the first time
5. Doesn’t account for regional differences in the cost of living

Question 8

What is Retail Prices Index (RPI)?

Answer 8

• RPI is another measure of inflation in the UK that includes a broader range of expenditures than CPI.
• It is used for various purposes, including index-linked bonds and some pension calculations.

Question 9

What of RPI is different from CPI?

Answer 9

RPI tends to produce a higher inflation rate than CPI because it includes housing costs and uses a different formula.

Question 10

What are the general causes of inflation?

Answer 10

Question 11

Explain demand pull inflation

Answer 11

• Demand-pull inflation occurs when total demand for goods and services exceeds aggregate supply. As the economy approaches full employment (or full capacity), labour and raw material shortages occur more frequently which then makes it more difficult for firms to expand production to meet rising demand.
• Furthermore, when the total demand in the economy rises, it encourages producers to raise their prices and increase their profit margins. This causes the economy’s general price level to rise. The closer to full capacity that the economy gets, the more rapid the increase in the price level.
• Demand-pull inflation is usually associated with an increase in real GDP i.e. economic growth, and an increase in employment levels in an economy.

Question 12

What does demand pull inflation look like?

Answer 12

Rightwards shift in AD

Question 13

Explain cost push inflation

Answer 13

Cost-push inflation occurs when the costs of production for businesses increase; this can include increases in wage costs, the cost of raw materials, rents, or indirect taxes such as VAT. With cost-push inflation, output of goods and services and employment both tend to fall; this is because a rise in costs often leads to a fall in business profits and planned investment spending. Cost-push inflation can bring about stagflation; this is a combination of slow growth and rising inflation. The most notable period of stagflation occurred during the 1970s, when world oil prices rose dramatically, and UK inflation rose at one point to nearly 30 per cent.

Question 14

What does cost push inflation look like?

Answer 14

Cost-push inflation originates from leftward shifts in aggregate supply (SRAS)

Question 15

Explain growth of the money supply as a cause of inflation.

Answer 15

When an economy’s money supply is increased more quickly than the economy’s growth rate, we can expect there to be inflation. Sometimes this is expressed as “too much money chasing too few goods”. One theory that has been used to explain this relationship between the money supply and inflation is the quantity theory of money; this can be expressed using the Fisher Formula of MV = PT (where M is the money supply, V is the velocity of money (i.e. how many times it changes hands), P is the price level and T represents the volume of output. We tend to assume that V and T are constant. So, if there is an increase in M then P will rise. Some famous periods of hyperinflation (e.g. Germany in the 1920s and Zimbabwe in 2008) are often attributed to increases in the money supply.

Question 16

Who are the winners of rising inflation?

Answer 16

• Workers with strong wage bargaining power (perhaps workers who belong to strong trade unions), because
  they can usually push for wage increases in line with price increases
• Debtors if real interest rates on loans are negative – the real value of debt may fall (note: real interest rates =
  nominal interest rates – inflation rate)
• Producers if their prices rise faster than costs
• Wealthy groups if there is a sustained period of asset price inflation

Question 17

Who are the losers of rising inflation?

Answer 17

• Retired people on fixed incomes – inflation erodes the real value of their pensions and other savings
• Lenders if real interest rates on loans are negative
• Savers if real returns on bank deposits are negative
• Workers in low-paid jobs with little or no bargaining power
• Exporting firms may lose sales and profits if they become less competitive – hitting shareholders

Question 18

Explain the process of calculating an inflation rate from CPI.

Answer 18

• A base year for prices is selected, and a family expenditure survey is carried out – the survey covers many
  thousands of UK households. The survey tracks what people are buying.
• A representative basket of over 600 goods and services is used, and weights are attached to each item -
  based on these items’ importance in people’s expenditure.
• Each month UK officials collect 120,000 separate price quotations in 141 locations of around 600 products.
• Weights are then multiplied by price changes
• The weighted price changes are then totalled to calculate the inflation rate.

Question 19

What are domestic causes of inflation?

Answer 19

Inflationary pressures within the domestic economy come – for example – from rising wage costs and
increases in the costs of component parts of raw materials.

Question 20

What are external causes of inflation?

Answer 20

• These are inflationary pressures from outside of a particular country – for example arising from an increase in the global price/cost of energy and other inputs
• Movements in the exchange rate of a country’s currency can also affect inflation. For example, if the currency weakens (i.e. becomes cheaper in terms of other currencies) then that will cause imported goods (e.g. raw materials) to become more expensive, pushing up domestic production costs

Question 21

What is the importance of inflation expectations?

Answer 21

• Once inflation becomes established in an economy it can be difficult to remove.
• Most agents (e.g. workers, businesses and lenders) will raise their inflation expectations and build it into their
  calculations and decisions
• A rise in inflation can lead to an increase in inflation expectations. This can feed through to higher wage claims and rising costs

Question 22

What are 7 risks of high and volatile inflation?

Answer 22

1. Inequality: Inflation has a regressive effect on lower-income families in developed & developing countries –
   most of their wealth is held in cash
2. Falling real incomes – if wage rises lag behind price increases each year
3. Negative real interest rates: If interest on savings is lower than inflation – this will cut real incomes of savers
4. Cost of borrowing: High inflation may also lead to higher interest rates for businesses and consumers with
   debts (e.g. Rising mortgage rates)
5. Risks of wage inflation: This leads to rising labour costs and lower profits
6. Business competitiveness: A high relative rate of inflation can reduce competitiveness which will lower demand
   for the country’s exports in overseas markets
7. Business uncertainty: High and volatile inflation is not good for confidence partly because businesses cannot
   be sure of what their costs and prices are likely to be. Uncertainty might lead to a fall in capital investment

Question 23

What could the effects of high inflation depend on?

Answer 23

1. Whether high inflation is temporary or a persistent problem
2. The rates of inflation in economies of major trading partner/competitor countries – this affects the scale of
   lost competitiveness
3. The extent to which a country’s central bank is prepared to tolerate inflation without raising interest rates
4. The wage bargaining power of workers in different industries
5. Whether nominal interest rates on savings and loans keep pace with inflation
6. Whether uncertainty leads to a fall in domestic and foreign inward investment

Question 24

Explain fiscal policy

Answer 24

Fiscal policy refers to any government policy involving a change in tax or government spending.
A “tightening” of fiscal policy could include less spending on state-provided services, reduced welfare
payments or raising direct taxes to cut household disposable income. This would cause AD to shift left and
help reduce demand-pull inflation.

Question 25

Explain monetary policy

Answer 25

Monetary policy refers to any policies relating to interest rates, the money supply and/or the
exchange rate. Inflation could be reduced by:
* a tightening of monetary policy via higher interest rates or tougher controls on commercial bank lending
* higher interest rates causing the exchange rate to appreciate bringing cheaper imported goods and services which leads to a reduction in the consumer price index

Question 26

What are supply side policies?

Answer 26

Policies that cause the productive capacity of the economy to increase) - increase productivity, competition and innovation within markets

Question 27

What are direct controls?

Answer 27

• Public sector wage controls such as a 1% pay cap increase for teachers and NHS workers
• Capping or other regulation of prices of utilities such as water bills or electricity/gas

Question 28

What are demand side causes of deflation?

Answer 28

we sometimes call this malign deflation
* Deep fall in total demand in an economy, causing a persistent recession / depression
* This is usually characterised by a high level of spare capacity

Question 29

What are supply side causes of deflation?

Answer 29

we sometimes call this benign deflation – total supply in an economy rises
more quickly than total demand
* Improved productivity of labour and capital
* Technological advances in the production process that lowers unit costs
* Falling wage rates
* High (strong) exchange rate causing import prices to fall (causing short run AS to shift outwards)

Question 30

Explain the economic effects of deflation

Answer 30

1. Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future.
   This lowers aggregate demand and can cause a deeper fall in real GDP i.e. prolonged recession
2. Debts increase: The real value of debt rises when there is price deflation and higher real debts can be a big
   drag on consumer confidence and spending
3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line
   with prices.
4. Lower profit margins: Lower prices reduce revenues & profits for businesses - this can lead to higher
   unemployment as firms reduce costs by shedding labour.
5. Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector
   wealth and confidence
6. Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may
   then default on loans
7. Deflation can make exporters more competitive eventually – but this often comes at a cost i.e. a higher rate
   of unemployment in the short term