Chapter 25 - Inflation Flashcards
What is inflation?
The rate of change of price level: for example, the percentage annual rate of change of the consumer price index.
What is a index number?
A way of comparing the value of a variable with a base observation such as a location or past period (e.g. the retail price index measures the average level of prices relative to a past year, known as a base period)
This technique is used to show the average level of prices at different points in time. For such a general price index, one procedure is to define a typical basket of commodities that reflects the spending pattern of a representative household. The cost of that bundle can be calculated in a base year, and then in subsequent years. The cost in the base year is set to equal 100, and in subsequent years the index is measured relative to that base date, thereby reflecting the change in prices since then. For example, if in the second year the weighted average increase in prices were 2.5%, then the index in year 2 would take on the value 102.5 (based on year 1 = 100). Such a general index of prices could be seen as an index of the cost of living for the representative household, as it would give the level of prices faced by the average household relative to the base year.
How do we calculate index number?
The current value of the index could be calculated as the current value divided by the base value, multiplied by 100.
What is consumer price index (CPI)?
A measure of the general level of prices in the UK, adopted as the government’s inflation target since December 2003
What is CPIH?
A version of the CPI that takes into account the housing costs of owner-occupiers and the council tax
What is retail price index (RPI)?
A measure of the average level of prices in the UK
What are the differences between the CPI and RPI?
The CPI, CPIH and RPI differ for a number of reasons, partly because of differences in the content of the basket of goods and services that are included, and partly in terms of the population of people who are covered by the index. For example, in calculating the weights, the RPI excludes pensioner households and the highest-income households, whereas the CPI does not. There are also some other differences in the ways that the calculations are carried out. RPIX removes mortgage interest payments from the RPI.
What is deflation?
A fall in the average level of prices (negative inflation)
What is disinflation?
A fall in the rate of inflation
What is hyperinflation?
A situation in which inflation reaches extreme or excessive rates.
What is cost-push inflation?
Inflation initiated by an increase in the costs faced by firms, arising on the supply side of the economy
What is demand-pull inflation?
Inflation initiated by an increase in aggregate demand
How does cost-push inflation work?
Suppose there is a one-off permanent rise in the price of oil. Such an increase means that firms face higher production costs, - because oil is a key input. Therefore, this is one reason why prices may begin to increase. In the AD/AS model, this would be seen as a decrease in short-run aggregate supply. In this way, inflation may be initiated by an increase in the costs faced by firms. This is referred to as cost-push inflation, as the increase in the overall level of prices is cost-driven. However, the AD/AS diagram only shows that there would be a one-off increase in the price level, which is not the same as saying there would be persistent inflation.
How does demand-pull inflation work?
An alternative explanation for a rise in the general price level could come from the demand side, where an increase in aggregate demand leads to a rise in prices, especially if the economy is close to its full capacity. An increase in the price level emanating from the demand side of the macroeconomy is referred to as demand-pull inflation. An increase in aggregate demand can arise from an increase in any of the components of aggregate demand, or from a cut in taxes. In terms of the AD/AS model, an increase in expenditure by consumers, firms or government would cause a rightward shift in AD, as would an increase in exports or a decrease in taxes. However, the AD/AS diagram again shows
that there would be a one-off increase in the price level, which is not the same as saying there would be persistent inflation.
What is money stock?
Why should there be persistent increases in prices over time? The AD/AS model shows that there may be one-off movements in either aggregate demand or aggregate supply that may lead to one-off changes in the overall price level, but unless the movements continue in subsequent periods there is no reason to suppose that inflation will continue. One explanation is provided by changes in the supply of money circulating in an economy.
Persistent inflation can take place only when the money stock grows more rapidly than real output. This can be shown in terms of aggregate demand and aggregate supply. If the money supply increases, firms and households in the economy find they have excess cash balances: that is, for a given price level they have more purchasing power than they expected to have. Their impulse will therefore be to increase their spending, which will cause the aggregate demand (AD) curve to move to the right. They will probably also save some of the excess, which will tend to result in lower interest rates - which will then reinforce the increase in aggregate demand. However, as the AD curve moves to the right, the equilibrium price level will rise, returning the economy to the full employment equilibrium.
If the money supply continues to increase, the process repeats itself, with prices then rising persistently. One danger of this is that people will get so accustomed to the process that they speed up their spending decisions, which simply accelerates the whole process.
To summarise, the analysis suggests that, although a price rise can be triggered on either the supply side or the demand side of the macroeconomy, persistent inflation can arise only through persistent excessive growth in the money stock.
How is uncertainty and investment a consequence of inflation?
If firms cannot confidently predict the rate of change of prices, the increase in uncertainty may be damaging, and they may become reluctant to undertake the investment that would expand the economy’s productive capacity.
How is resource allocation a consequence of inflation?
Prices are very important in allocating resources in a market economy. Inflation may consequently inhibit the ability of prices to act as reliable signals in this process, leading to a wastage of resources and lost business opportunities.
How is effects on income distribution a consequence of inflation?
As inflation accelerates, there could be an increase in inequality in the distribution of income, because some groups in society are less able to protect themselves against rising prices. In particular, pensioners and others on fixed incomes find the value of their incomes (and savings) are diluted by rising prices.
How is effect on wages a consequence of inflation?
Another consequence of high inflation is that workers negotiate for higher wages to compensate for the increase in prices. This further increases the costs faced by firms, which may reinforce the inflationary process.
How is menu and shoe-leather costs a consequence of inflation?
When inflation is very high and volatile, firms have to keep amending their price lists, which raises the costs of undertaking transactions. These costs are often known as the menu costs of inflation - however, these should not be expected to be significant unless inflation really is very high. A second cost of very high inflation is that it discourages people from holding money because, at the very high nominal interest rates that occur when inflation is high, the opportunity cost of holding money becomes great. People therefore try to keep their money in interest-bearing accounts for as long as possible, even if it means making frequent trips to the bank - for which reason these are known as the shoe-leather costs of inflation.
How is inflation as a policy objective a consequence of inflation?
Although the menu costs and shoe-leather costs become important only at quite high rates of inflation, the potential negative consequences of inflation have elevated the control of inflation to one of the central planks of UK government macroeconomic policy. However, it should be noticed that the target for inflation has not been set at zero. During the period when the inflation target was set in terms of RPIX, the inflation target was 2.5%. From 2004 the target for CPI inflation was 2%.
The reasoning here is twofold. One argument is that it has to be accepted that measured inflation will overstate actual inflation, partly because it is so difficult to take account of quality changes in products such as smartphones, where it is impossible to distinguish accurately between a price change and a quality change. Second, wages and prices tend to be sticky in a downward direction: in other words, firms may be reluctant to lower prices and wages. A modest rate of inflation (e.g. 2%) therefore allows relative prices to change more readily, with prices rising by more in some sectors than in others. This may help price signals to be more effective in guiding resource allocation.
