3.4 Price Stability

Question 1

Inflation definition

Answer 1

Sustained increase in the average price level of an economy over a given period of time

Question 2

Deflation definition

Answer 2

Sustained decrease in the average price level of an economy over a given period of time

Question 3

Disinflation definition

Answer 3

A fall in the rate of inflation

Question 4

Measuring inflation

Answer 4

• measured using the rate of change in the consumer price index (CPI)
• representative basket of goods and services for a typical UK households,

Question 5

Measuring inflation equation

Answer 5

Inflation rate = (index value in a given year - index value in previous year)/ index value in previous year x 100

Question 6

Real vs nominal GDP

Answer 6

Real - the value of an economic variable that takes account of changes in the general price level over time
Nominal - the value of an economic variable based on current prices

Question 7

Causes of inflation (demand)

Answer 7

• Demand-pull inflation, higher levels of aggregate demand may lead to an increase in the price level - eval, depends on what is happening to the productive capacity of the economy, and depends on how close the economy is to full employment, greater inflation rates if economy is close to productive capacity

Question 8

Causes of inflation (supply)

Answer 8

Cost-push inflation, higher costs of production in the economy will lead to an increase in the price level

Question 9

Wage price spiral

Answer 9

An increase in price level, means workers demand higher wages, leads to higher costs to firms, firms increase prices causing an increase in price level

Question 10

Consequences of inflation (consumers)

Answer 10

• loss of consumer confidence, value of money is decreasing, consumers will be unsure what they are able to afford, causes consumers to save more
• real income may fall, the real value of money falls, workers are able to purchase less goods and services, reduction in standard of living - eval, depends if workers wages increase inline with inflation rates
• real value of debt falls, debt is essentially cheaper, less significant with mortgages in house prices are also rising
• unemployment if inflation leads to lowered confidence in the economy, this will reduce output and firms will demand less labour

Question 11

Consequences of inflation (producers)

Answer 11

• reduced business confidence, uncertainty around future prices, may lead firms to reduce investment, leading to decline in aggregate demand
• menu costs, costs with firms having to change there prices, the higher the rate of inflation, the more frequently producers will have to change there prices
• reduced competitiveness, higher prices may lead the UK economy to become less competitive, total imports may increase, causing lower aggregate demand
• more flexibility with wages firms may be able to reduce the real wages of workers if the nominal wage increase is less than the rate of inflation

Question 12

Consequences of inflation (government)

Answer 12

• real value of government debt is reduced, the government is a net borrower, real value of debt decreases during times of inflation
• increased goverment payments, benefit payments will increase in line with inflation as well as public sector wages will be forced to increase inline with inflation

Question 13

Evaluating the consequences of inflation

Answer 13

The extent of the consequences of inflation depends on:
- the size of the increase of the rate of inflation
- the extent to which nominal GDP and incomes increase, if nominal increase in income is greater than inflation than there is still a real increase in incomes
- the duration of inflation, long-term inflation is likely to be more costly
- the cause of inflation, demand-pull inflation is less costly than cost-push inflation