2.5.3 Inflation

Question 1

Price indices

Answer 1

Measures changes in the general level of prices → weighted averages of price changes based on average levels of spending on a wide range of consumer goods and services

Question 2

Consumer price index

Answer 2

Headline rate and forms the basis for the government’s inflation target → excludes mortgage interest payments and housing costs

Question 3

Retail price index

Answer 3

Includes housing costs (council tax) and mortgage interest payments → used to decide state pension and benefit levels

Question 4

what is inflation

Answer 4

• General and consistent rise in the level of prices
• Inflation causes high prices → consumer spending goes down as we cannot afford as many goods and services → standard of living goes down

Question 5

CPI and RPI

Answer 5

• Measures the rate of inflation in the uk
• Annual price percentage change in the average level of prices from year to year
• Basket of goods selected and their prices are monitored at regular intervals (things a average family would buy)
• Each good or service is given a weight so that their relative importance in spending is taken into account
• Price indice: base year of 100

Question 6

calculating index numbers

Answer 6

• Find percentage change between prices in year 1 and 2 and add/subtract onto 100
• Divide by total itemps to find overall index

Question 7

calculating weighted index number

Answer 7

• Find percentage change between prices in year 1 and 2 and add/subtract onto 100
• Times by weight
• Divide by total by weightto weighted index
• Inflation has more of an impact when weighted index is taken into account → more accurate interms of the impact on price agents in the economy

Question 8

demand pull inflation

Answer 8

• Caused by too much money chasing too few goods
• Aggregate demand in the economy outweighs the economy’s ability to supply (AS)
• This occurs as the economy grows and near full employment
• Can be caused by gov policies to boost AD, can be caused by rises in consumer confidence in the economy
• Can be solved by reducing AD through higher interest rates, leads to lower growth rates

Question 9

how is demand pull inflation tackled

Answer 9

• Supply side policies aimed at increasing AS, training programmes, Investment in technology to boost productivity, encouraging people back to work through changes in a benefit system etc
• Govs use a mixture of both demand management and supply-side policies
• Economic growth leads to inflationary pressure → higher interest rates encourage saving and make borrowing more expensive, discouraging consumption and investment
• However, when economic growth slows and the economy needs stimulating, interest rates are cut to boost demand in the economy; lower interest rates discourage saving and making borrowing cheaper so encouraging consumption and investment

Question 10

cost push inflation

Answer 10

• Caused by an increase in the costs of production
• Increased cost of raw materials eg oil
• Higher wages, salaries, and physical office space; not linked to rises in productivity
• Changes in the exchange rate making imported raw materials more expensive
• Cost push inflation can be cured by policies such as wage restraint in the public sector → but some factors, rising oil prices can be harder to control
• Can reduce the wages of public sector workers low

Question 11

what are the impacts of inflation

Answer 11

• Redistrubutional costs → tax can increase if income increases due to inflation
• Living standards decrease, but for whom? Depends if income increases by the same percent, or if they are relying on savings, pensions or benefits (fixed incomes)
• Poor economic performance → leads to unemployment and low growth rates; as UK prices rise, business becomes less competitive and as uncertainty grows, entrepreneurs are less likely to take risk
• UK business growth suffers and unemployment rises
• Imports increase, exports decrease, and consumer spending decreases leading to economy to get smaller (AD = C + I + G + (X-M))
• Psychological and political costs → rising prices are unpopular and often lead to social and political change
• Hitler and W germany, Thatcher and winter of discontent
• Depend on the extremity
• Menu costs → firms have increased admin cost as they have to re label goods → clothing, food etc
• Shoe leather costs → when prices are moving, consumers and firms spend additional time shopping around

Question 12

costs of inflation on firms

uncertainty

Answer 12

• Uncertainty
• Hard to make accurate cash flow, cost and revenue forecasts because prices and costs are constantly changing → difficult to forecast future profits
• Plans to invest and expand production become riskier so inflation is likely to lead to lower investment
• Loss of competitiveness
• Can make exports less competitive if competing economies have lower inflation rates
• Inflation happens in a boom, so firms may experience skill shortage
  rival businesses may poach employees so firms may have to pay higher wages to keep the skilled labour/attract more labour

Question 13

cost of inflation on individuals

Answer 13

• Loss of real income → rate of inflation may be larger than interest rate on savings
• People on fixed incomes suffer as they are not raised in line with inflation (pensioners and people on benefits)
• Savers and borrowers
• Money loses value and people lose confidence in money as real value of their savings is reduced
• People who borrow gain as overtime the value of money falls, so the amount they repay is worth less than what it was when they first borrowed
• Counter inflation policies may reduce demand (DPI), so employees can be made redundant