3.5 - Inflation Flashcards
Define ‘inflation’
Rate of increase in the average price level in an economy
Methods to calculate inflation?
Measured by CPI (Consumer price index) and RPI (retail price index)
How does CPI help economic agents?
Households: understand market trends, allows households to understand their disposable income and plan their spending, ask for higher wages for inflation
Firms: adjust price based on inflation, to understand market trends, monitor cost of production
Government: adjust policies and action (tax cut), welfare benefits, national minimum wage
Definite index number
A figure reflecting price or quantity compared with a base value.
Define CPI
Measure of the general price level in the UK
How is inflation calculated using CPI?
- Expenditure survey is carried out
- A consumer basket of most popular goods is formed with average price attached
- Price of these goods or services are weighed based on the % of income
- Weighted prices are added to give a total weighted price of the basket
- Base year selected with index value of 100
- Weighed basket prices are converted into index numbers
- % Change is calculated to work out annual inflation rate
- Basket is updated yearly
Limitation of CPI
- CPI not fully representative - as it represents the “average” consumer, it will be inaccurate for non-typical consumers. Eg 14% of index devoted to motoring expenses, does not apply for non-car owners.
- CPI slow to respond to new products and services - as CPI only updates once a year, unable to capture all major changes in consumer spending pattern
- Different people have different spending pattern eg child vs family
- Changing quality of goods and services, rise in price may not indicate quality improvements
- Regional differences in cost of living
Alternative measurement of inflation
RPI - measure of average level of price in uk
was replaced with CPI due to EU countries using CPI, allowing fairer comparisons.
CPI measured effects of microeconomic policy changes more effectively
Similarities and differences between CPI and RPI
Similarities: both measured overall price level at different time points
Both indices show how general price level changed relative to the base year
Differences: RPI includes housing costs (mortgage interest payments, council tax, estate agent fees. CPI does not, underestimating inflation.
RPI excludes highest and pensioner households (dependent on benefits) = higher rate than CPI
CPI includes university tuition fees, more modern.
Causes of inflation
- Cost-push inflation (caused by increase in COP eg wage faced by firms, arising on the supply side of the economy, price increases to maintain profit margins)
- Demand-pull inflation (caused by an increase in AD)
- Increase in money supply, (quantity of money increases) lowered interest rate, more spending
Consequences of inflation
LCUUPF
- Less competitive abroad (higher COP -> higher price -> less competitive for exports)
- Uncertainty for firms’ planning and investing (cautious of spending, cut back on investing, lead to fall in AD)
- Unemployment (due to lack of competition and uncertainty, greater inequality)
- Purchasing power fall (those with fixed income will have less purchasing power, standard of living decreases)
- Fiscal drag, workers with increased income will pay more taxes
Why does the bank aim for 2% inflation rate as oppose to 0%?
Inflation indicates rising demand in the economy, and that increase in supply is keeping up with the increase in demand. Shows growth in economy.
Firms do not cut price and wages as may demotivate workers
Low and stable rate, expected by agents can act as effective signal to the economy,
Problems of deflation CCBP
- Consumers postpone consumption to expect price fall further
- Consumer confidence drops and savings rise (price in housing decreases, consumers refuses to purchase, fear of losing value) further decline of AD and rise in savings
- Real cost of borrowing increases (nominal rates do not fall with deflation, cost of borrowing increases, lead to less borrowers, fall in AD)
- Lower profit margin (profits margins under pressure unless cost decreases, lead to unemployment due to cutting COP, lower profit margin also leads to negative effect on stock market due to fall profits to stockholders and dividends)
Define deflation
Persistent fall in the average price level, negative inflation
Define disinflation
Fall in the rate of inflation
