3.4 Price stability

Question 1

Define price stability

Answer 1

When the general price level either stays the same or rises at a low rate over time

Question 2

Define inflation

Answer 2

A sustained increase in the general price level

Question 3

Define real values

Answer 3

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

Question 4

Define nominal values

Answer 4

The value of an economic variable based on current prices

Question 5

What is the difference between real and nominal values?

Answer 5

• A real value takes account of inflation whereas a nominal value does not take this into account (e.g. if the rate of interest for a savings account is advertised as 4%, this is the nominal rate of interest. If the rate of inflation is 2.5%, then the real rate of interest is 1.5%)

Question 6

Define consumer price index (CPI)

Answer 6

A measure of the general price level used to calculate the inflation rate

Question 7

How is inflation measured by the consumer price index (CPI)?

Answer 7

1- Surveys consumers to create a basket of goods and services that they are buying
2- Tracks how much they buy of these goods and services so they can give them more importance within the basket (known as weighting)
3- Checks the prices of these goods and services every month
4- Uses index numbers to show the overall change in this general price level compared to a base year

• The CPI is set at 100 in the base year
• Any number above 100 show that inflation has risen

Question 8

How do you calculate the change in price due to inflation?

Answer 8

original price/100 X inflation rate

Question 9

What are the causes of inflation?

Answer 9

• Too much demand (demand-pull inflation)
• Rise in costs (cost-push inflation)

Question 10

What is demand-pull inflation?

Answer 10

• It happens when total demand rises faster than total supply in a country
• One cause is increased incomes, because consumers are able to afford more goods and services
• This means there is increased competition for these goods and services, which lead to higher prices

Question 11

What is cost-push inflation?

Answer 11

• It is caused by a rise in costs of production, which firms try to pass onto consumers to maintain profits. This leads to a rise in the general price level.
• Costs of production include: wages/salaries, raw materials, fueld, tax contributions etc

Question 12

What are the consequences of inflation (for consumers)?

Answer 12

• Loss of consumer confidence: inflation makes it more difficult for consumers to value different goods and to decide how to prioritise spending their income, so the uncertainty may stop them buying goods and services
• Shoe leather cost: as prices change with inflation, consumers and firms have to keep comparing prices of different goods from different suppliers, this costs time and
  effort to find the best deals.
• Fall in real income: if income rises at a slower rate than inflation, consumers will have less purchasing power, and their standard of living falls

Question 13

What are the consequences of inflation (for producers)?

Answer 13

• Increased production costs: inflation may increase the price of production, increasing costs and potentially reducing profits.
• Menu costs: firms may have to update pricing information on their goods due to inflation, reducing profits
• Loss of business confidence: if firms are uncertain about the costs of production and the selling price of their goods, this may make them reluctant to invest, leading to lower productivity

Question 14

What are the consequences of inflation (for savers)?

Answer 14

• If inflation is positive, it reduces the purchasing power of money and means that a fixed amount of money can buy fewer goods and services after a period of inflation
• Inflation reduces the impact of any interest and may reduce the real value of the money saved (e.g. if someone is saving for a new car but the price of the car rises faster than the rate the person can sav)

Question 15

What are the consequences of inflation (for governments)?

Answer 15

• Tax revenue: if there is inflation, some tax revenue may increase (e.g. income tax may increase if it is a percentage of higher incomes and people may be dragged into higher tax brackets)
• Government as benefits provider: benefits may be linked to a rise in line with inflation, this means an increase in government spending
• Government as employer: inflation leads to pressure on government to increase wages for its employees (increased government spending)