2.5.3 inflation

Question 1

What is inflation?

Answer 1

The sustained rise in the general price level over time. This means the cost of living increases and purchasing power of money decreases.

Question 2

What is deflation?

Answer 2

The opposite of inflation, where the average price level in the economy falls. There is a negative inflation rate.

Question 3

What is disinflation?

Answer 3

Is the falling rate of inflation, this is when the average price level is still rising but at a slower extent.

Question 4

How is the rate of inflation calculated in the UK?

Answer 4

Using the Consumer Prices Index (CPI).

Question 5

How does the CPI work?

Answer 5

It measures household purchasing power with the Family Expenditure Survey. The survey finds out what consumers spend their income on, and from this a basket of goods is created.

The goods are weighted according to how much income is spent on each item. Petrol has a higher weighting than tea, for example. Each year the basket is updated to account for changes in spending patterns.

Question 6

What is the government macroeconomic objective for inflation in the UK?

Answer 6

To be at 2%.

Question 7

What are the key points when answering an exam question on CPI? [4]

Answer 7

• A survey is used
• Weighted basket of goods
• Measures average price change of the goods
• Updated annually

Question 8

What are the limitations of CPI when measuring inflation? [4]

Answer 8

• Basket of goods is only representative of the average household, so is not accurate for households who do not own cars, for example, and therefore do not spend 14% of their income on motoring
• Different demographics have different spending patterns
• Housing costs account for about 16% of the index, yet this varies between people
• CPI is slow to respond to new goods and services, even though it is updated regularly

Question 9

What is an alternative measure of inflation to CPI?

Answer 9

The Retail Price Index (RPI)

Question 10

What is the difference between CPI and RPI?

Answer 10

RPI includes housing costs, such as payments on mortgage interest and council tax, and is why RPI tends to have a higher value than CPI.

Question 11

What are real values?

Answer 11

These are values which are adjusted for inflation. For example, real GDP is the value of GDP adjusted for inflation.

If the economy grew by 4% but inflation was 2% then real economic growth was 2%.

Question 12

What are nominal values?

Answer 12

These are not adjusted for inflation. This is misleading because it can make GDP appear higher than it really is.

Question 13

What is demand pull inflation?

Answer 13

When AD is growing unsustainably, there is pressure on resources. Producers increase their prices and earn more profits. Usually occurs when resources are fully employed.

Question 14

What are the main triggers for demand pull inflation? [4]

Answer 14

• Depreciation in the exchange rate, which causes imports to become more expensive, whilst exports become cheaper, causing AD to rise
• Fiscal stimulus in the form of lower taxes or more government spending, meaning consumers have more disposable income, so consumer spending increases
• Lower interest rates makes saving less attractive and borrowing more so, and so consumer spending increases
• High growth in UK export markets means UK exports increase and AD increases

Question 15

What is cost push inflation?

Answer 15

When firms face rising costs and so prices increase.

Question 16

What are the main triggers for cost push inflation? [6]

Answer 16

• Changes in world commodity prices can affect domestic inflation
• Labour becomes more expensive
• Expectations of inflation, if consumers expect prices to rise, they may ask for higher wages to make up for this
• Indirect taxes could increase costs of goods if the producers choose to pass the costs onto consumers
• Depreciation in the exchange rate, causing imports to become more expensive
• Monopolies, using their dominant market position to exploit consumers with high prices

Question 17

What are the impacts of inflation on workers? [2]

Answer 17

• Real incomes fall with inflation, so workers will have less disposable income
• If firms face higher costs, there could be more redundancies when firms try and cut their costs

Question 18

What are the impacts of inflation on consumers? [2]

Answer 18

• Those on low and fixed incomes are hit hardest, due to its regressive effect and cost of necessities becomes more expensive. Purchasing power of money fall
• If consumers have loans, the value of the repayment will be lower, because the amount owed does not increase with inflation, so the real value of debt decreases