3.4 Price stability

Question 1

What is price stability?

Answer 1

When general price levels remain the same or rise at a low rate over time

Question 2

What is inflation?

Answer 2

A sustained increase in general price levels.

Question 3

What can inflation lead to?

Answer 3

To a fall in purchasing power, where consumers can buy less with the same amount of money. In other words, the cost of living increases

Question 4

What is meant by the general price level?

Answer 4

The measure of the overall prices of goods and services of in an economy at a particular point of time

Question 5

What is meant by the rate of inflation?

Answer 5

The percentage rise in the general price level over a period of time

Question 6

Can inflation be negative?

Answer 6

Inflation can be negative

Question 7

What is a nominal value?

Answer 7

A nominal value is the value of something in money terms

Question 8

What is a real value?

Answer 8

The value of an economic variable that takes account of the changes in the general price level over time

Question 9

What is the difference between real and nominal values?

Answer 9

Real values take into account inflation, whereas nominal values don’t.

Question 10

What does the real value of a workers wage refer to?

Answer 10

To the goods and services that can be bought with that wage.

Question 11

Say a worker earns £400 pounds, with this money she is able to buy x amount of goods in 2016. Now in 2017, she still earns the same amount however in this case to buy the exact same amount of goods as in 2016, she will need £420 pounds. What has happened in terms of inflation and her real wage?

Answer 11

Inflation has increased buy 5% and her real wage has fallen

Question 12

What would need to happen for her real wage to remain the same?

Answer 12

A 5% increase in her money wage

Question 13

Say her wages increased to £410, explain what has happened in terms of nominal and real wages

Answer 13

Her nominal wage has risen, however her real wage has still fallen since she will still not be able to buy all the goods that she was able to buy back in 2016

Question 14

What is meant by the consumer price index?

Answer 14

A method used to calculate the rate of inflation

Question 15

How is inflation measured using the CPI?

Answer 15

The gov undertakes a survey to determine the goods and services the average UK families spend their money on. This is known as a basket of goods and services. It records the prices of all the goods and services in this basket every month. This recording of prices is done at hundreds of different outlets in which families buy their goods and services from. These figures are recorded in the CPI. The CPI is given the number 100 at the start of the period and if prices rise in the next month this will be reflected in the index. For example if the price of the goods in the basket have risen by 2% overall, then the index rises to 102

Question 16

What is done to make CPI more accurate?

Answer 16

The gov uses a system called weighting, where each item in the basket is given a weight, which represents its importance in the total spending of the average family.

Question 17

When the rate of inflation is positive, the general price level is rising. But what happens to the price level when the rate of inflation falls?

Answer 17

The price level will still be rising so long as the rate of inflation is positive

Question 18

When does the price level actually fall?

Answer 18

When the inflation rate is below zero

Question 19

What are the 2 main causes of inflation?

Answer 19

• Too much demand

- Rise in costs

Question 20

Explain demand-pull inflation?

Answer 20

Demand-pull inflation is caused when the total demand in the economy rises and supply of goods and services does not rise to match the increase in price, so the price level is pulled up.

Question 21

Where can this rise in demand come from?

Answer 21

• Consumers: in times in of a boom in the economy. There are higher levels of employment and higher incomes per capita, so the total consumer demand rises.
• From firms that demand capital goods for investment, consumers in foreign countries who buy exported goods and services, and the gov, which spends more, for example on health and education.

Question 22

What is monetary inflation?

Answer 22

When there is a rise in the money supply which enables consumers to demand more good and services, which in term pulls the price level up

Question 23

When is demand pull inflation more likely to happen?

Answer 23

When an economy is near full employment. the available factors of production, including labour are being fully used, so the economy cannot produce anymore output in the short run as its already producing its maximum. consequently the price level rise up since demand will also be rising and there is less supply.

Question 24

Explain cost-push inflation

Answer 24

Cost-push inflation is caused by higher costs of production, which producers then pass this cost on to consumers by increasing the prices. Costs of production include wages and salaries, materials, fuel, rent and business rates, and interest on loans. If these costs rise, then firms will try to maintain their profits by raising the prices of their goods and services.

Question 25

Explain the wage-price spiral

Answer 25

• There’s an initial rise in the general price level
• workers demand higher wages to compensate
• the workers wages rise
• the costs of production to the firm rise especially if the productivity of the workers doesn’t also rise
• firms put up their prices of goods and services
• the general price level rises further

Question 26

How is consumer confidence affected by inflation?

Answer 26

-lose of consumer confidence: when prices are stable consumers know the relative prices of goods and services, which allows them to plan their spending. They can work out what they can afford, and save up for future purchases since they know how much needs to be saved. Therefore price stability helps consumer confidence. However, if there is inflation, consumers no longer know the prices of goods, and no longer know what they can and cant afford, they also do not know how much money they will need to save since prices may or will be higher in the future. Therefore inflation reduces consumer confidence

Question 27

What are the 4 consequences of inflation for consumers other than lose of consumer confidence?

Answer 27

• shoe leather costs: as prices are changing with inflation, consumers are spending more time and effort comparing different prices of goods from different suppliers
• fall in real income: if incomes rise at a slower rate than inflation then consumers will need more money to be able to purchase the same amount of goods as they could have bought before, meaning their purchasing power falls
• income distribution: workers that belong to strong trade unions may be able to negotiate higher wages that keep up with inflation, allowing them to maintain a high standard of living. However, workers in low-paid jobs and weak bargaining powers may suffer a fall in their real wages and their standards of living may decrease.
• consumers as debtors: debtors gain in times of inflation because the real value of their debts decrease, in other words their debts get cheaper.

Question 28

What are the consequences of inflation to producers?

Answer 28

• increased production cost: inflation may increase the price of inputs, increasing costs and possibly reducing profits
• menu costs: firms have to adjust their price lists more often when there is inflation, leading to an increase in costs of production
• labour market disputes: workers will be aware of the increase in inflation and may demand a rise in wages in order to maintain their standards of living. Workers may even ask for a higher increase in wages that takes future inflation into account. the employers meanwhile are facing increased costs and possibly falling sales and so are unable or unwilling to give such a pay rise. this can lead to conflict between workers and employers, which may lead to industrial action such as strikes.
• lower exports: if inflation is higher in the UK than in other countries, then UK goods will seem relatively more expensive to overseas consumers, so they will no longer buy from the UK.
• producers as creditors: this includes banks who are owed money. if there is inflation, this means that the real values of their loans to borrowers may fall
• producers as debtors: firms with debts may gain as the real value of their debts falls
• loss of business confidence: when there is inflation, businesses are less likely to invest if they are uncertain about the future prices of inputs and their selling prices.

Question 29

what are the consequences of inflation for savers?

Answer 29

the money savers have saved will lose value in real term when there is inflation.

Question 30

What are the consequences of inflation for governments?

Answer 30

• gov as employer: inflation leads to pressure on the gov to increase wages of its employers, this can led to costly industrial disputes and if wage increases are agreed to then gov spending increases
• gov as benefit provider: benefits such as state pensions and unemployment benefits rise in line with inflation, meaning an increase in gov transfer payments
• tax revenue: if there is inflation, some tax revenue may increase, e.g. VAT and income tax. VAT may increase because it is a % of higher prices. income tax may increase if it is a % of higher incomes and people may be dragged into higher tax brackets. however taxes fixed at a set amount may fall in real terms