2.4 inflation Flashcards
define inflation
a sustained increase in the average price level. the rate of change of the average pice level - the % annual rate of change of the consumer price index
define disinflation
a fall in the inflation rate. it means that the general price level is increasing at a slower rate
define deflation
when there is actually a fall in the average PL (negative inflation)
define hyperinflation
a rapis and unchecked increase in the PL. typically it involves inflation rates of greater than 50% or even greater than 1000%
explain the policy objective of low/stable inflation
attempts to create stability in the overall equilibrium PL. gov’s target is 2% (CPI)
why is the target of low and stable inflation important
high/volatile inflation may deter firms from investing and therefore hinder EG. firms base investment decisions on future expectations. inflation makes it hard to form reliable expectations for the future. a stable macro environment is crucial for EG to happen
define nominal values in the context of inflation
the unadjusted rate or current price, without taking inflation into account
define real values in the context of inflation
adjustments are made for general PL changes (inflation) over time
how to calculate index numbers
current value of index = (current value/base value) x 100 –> to compare 2 years not including the base year calculate % change
how do we measure inflation
consumer prices index (CPI) and the retail prices index (RPI) - two baskets comprising different goods and services. both weighted price indexes based on how often goods are bought - changes in weight reflect shifts in spending patterns as measured by the family expenditure survey
difference between cpi and rpi
rpi includes housing costs like mortgage interest payments and council tax but cpi doesn’t
detail about the cpi
inflation rate is calculated each month by looking at changes in prices for over 700 goods and services in 150 different areas in the UK. known as the basket of goods and is regularly updated to reflect changes
how to calculate a weighted price index for this year
the sum of (price x weight)/ sum of the weights
how to calculate rate of inflation
the % change in price index from one year to another
advantages of using cpi and rpi to measure inflation
large categories make cpi a legit indicator, measurable (quantifiable)
disadvantages of using cpi and rpi to measure inflation
few households are exactly average, not fully representative of all households, different people have different spending patterns, new products may not be accounted for as the cpi is slow to respond to new products or services
name the causes/types of inflation
demand pull, cost push
explain demand pull inflation
higher aggregate demand pulls prices up. ad shifts to the right
explain cost push inflation
supply decreases because costs of production have increased. can be caused by higher wages, higher raw material prices, higher business taxes, higher cost of imports due to a weaker exchange rate. sras shifts to the left, increasing the PL
why should there be a persistent price increase over time
a moderate rate of inflation is consistent with a steady rate of EG
name consequences of inflation
- fall in the value of money - falling real incomes
- menu costs
- shoe leather costs
- inflationary noise/impact on resource allocation
- impact on inequality
- fiscal drag
- uncertainty and investment
- loss of international competitiveness
explain 1. fall in the value of money - falling real incomes
money can now buy less than it could the year before because of inflation as it’s worth less. consumers can buy less
explain 2. menu costs
restaurants constantly having to reprint menus due to changes in prices
explain 3. shoe leather costs
the cost of having to move money between different financial institutions to try and minimise the impacts of inflation (i.e having to carry your money and ‘walk’ to a different financial institution thus wearing out the leather of your shoes)
explain 4. impact on resource allocation
price usually acts as a way to decide where resources are allocated. inflation may mean it can’t reliably do this so resources are misallocated and business opportunities may be lost
explain 5. impact on inequality
some groups in society will be less able to protect themselves against rising prices so this increases inequality. eg pensioners and those on fixed incomes now have less buying power because their incomes/savings are diluted by rising prices and so they are some of the most disadvantaged
explain 6. fiscal drag
inflation means higher wages means people are in a higher tax bracket meaning they may be worse off as are losing more money to taxation
explain 7. uncertainty and investment
if firms can’t confidently say what the rate of inflation will be in the future this increases their uncertainty. more uncertainty can make them reluctant to undertake investments to increase their productive potential as they don’t know if demand will be high enough in the future to justify this
explain 8. loss of international competitiveness
higher inflation in a country may make other countries less inclined to buy goods from them as they’re more expensive so they buy goods from other countries instead
the benefits of inflation
low and stable demand pull inflation may encourage firms to increase their output, workers may feel more appreciated if their wages increase even if real pay doesn’t, allows firms to cut real wages - improving labour markets
evaluate the significance of inflation
the impact of it depends on the rate, the cause, the fluctuations, and the comparison with other economies. low stable rate is generally okay. cost push is more harmful as it usually leads to a fall in real gdp
why might deflation be economically damaging
- holding back on spending if consumers think it will be cheaper in future
- debts increase
- the real cost of borrowing increases
- lower profit margins
causes of deflation
falling ad, lower production costs
