Inflation Flashcards
What is inflation?
Inflation is the sustained rise in the general price level.
What is deflation ?
Is the fall in the general level of prices
What is disinflation?
Is the fall in the rate of inflation
How to calculate inflation using Consumer Price Index ( CPI)
1 Family expenditure survey
2 Basket of 650 goods and services
3 weights attached according to percentage of income spent.
4 base year selected
5 index numbers generated
6 monthly collection of data and the annual percentage change is measured
7 basket of goods and weights changed every year
What are the limitations of using CPI?
1- The basket may not be representative of all consumers.
2- data may be inaccurate and may be error in data collection
3- other countries use different measures. Makes comparison difficult
4- takes time for basket to change
5- if basket is changing then comparisons of past inflation become difficult.
What are the causes of inflation?
Demand pull inflation- when there is an increase in aggregate demand. An shift in AD moves us closer to full employment level of output in the economy, more pressure put on existing factors of production in the economy. When theres more pressure on factors of production price of them increase. Worker want higher wages, price of capital becomes higher due to scarcity, price of land increases as its scarcer. So overall this puts upward pressure on prices in the economy.
Cost push inflation- occurs when aggregate supply decreases i.e total costs of production increase
What are the causes of demand pull inflation?
Any factor that affects aggregate demand.
A decrease in interest rates.
A rise in the level of business and consumer confidence.
An increase in government spending
Exports rising relative to imports
Depreciation of the exchange rate ( increasing demand for exports and reducing demand for imports)
What are the causes of cost- push inflation?
anything that increases cost of production.
A rise in oil prices
A rise in taxes on business
An increase in wages
Increases regulations which increase cost
What is the growth of the money supply?
Based on the belief thay inflation is always a problem of too much money in the economy
What are the effects of inflation?
Consumers:
For those with fixed incomes- inflation implies that real incomes would fall
For those with savings- if rate of inflation is higher than the interest rate of savings, the real value of savings will decrease.
Firms:
Fall in exports- if UK rate of inflation is higher than its main trading partners, the Uks international competitiveness ( degree to which a countrys goods and services can be sold on international markets)) will fall. Exports become expensive and imports seem cheap. Worsens balance of trade
Uncertainty- high inflation makes it difficult for firms to set budges which results in a fall in investment.
Lower profits- cost- push inflation causes decreaese in profits which results in lower investment. However, some inflation may result in increased revenue. Which means profits increases if there is demand pull inflation which encourages them to invest.
Government:
Fall in real value of national debt- inflation reduces value of debt owed by the government so it becomes less of a burden
Increased inequality- inflation makes it more difficult for a government to reduce income inequality because those on fixed incomes will see a fall in the real value of their incomes
Worsens balance of trade- exports fall, imports increase.
Workers:
Unemployment: a low inflation may imply low demand in economy and high rate of unemployment
Wages decrease for those on fixed incomes.
What are the causes and consequences of deflation?
Consumers delay consumption- if they expect prices to fall in the future they will wait until prices are lower to buy. But if everyone does that aggregate demand falls, fall in demand in economy more likely for recession. Firms wont be happy so they will cut prices and makes everything worse.
Increases the real value of debt- if firms are cutting prices and see lower profit, wages are likely to fall. Firms cut wages, so debt which holds constant value, in real terms have become much higher. Makes it harder to pay that debt back. Incentive to borrow is gone so more savings.
Why is inflation actually bad?
As it has a number of adverse effects. For instance rising prices mean that the value of what savings can buy falls. If a person had £50 in savings and the price of a t shirt went up from £10 to £25 they would be worse off as their savings can only buy 2 compared to 5 before.
Another problem is that it disrupts knowledge of prices in a market.
What are the Costs of Inflation?
RUC
R ( Fall in REAL interest rates)- higher inflation causes the real interest rate to fall and so as a result borrowers will gain and lenders will lose. This may mean banks will be reluctant to lend money or may mean that they will raise their interest rates making it difficult for firms to borrow, resulting in lower investment and thus lower economic growth
U ( UNCERTAINTY)- Inflation can create uncertainty about future. If firms are uncertain about what their costs will be and what prices they will receive from selling their products they may be reluctant to invest. Inflation also makes it difficult for people to decide how much to save and where to place their savings.
C ( Loss of International competitiveness)- if a country’s inflation is above that of its main competitors, then the products that the country exports are rising in price faster than the price of the products they import. This is likely to result in a decrease in exports and rise in imports.
What are the disadvantages of deflation?
Discourages Consumption- when prices are falling, this encourages people to delay purchases of products because they will likely be cheaper in the future. This means you can increase the real value of your money by leaving it in a bank, as the purchasing power of your money increases when the price level falls. This increase in saving can lead to reduced consumption which can lead to lower investment and thus lower economic growth.
Increases the Real value of debt- Deflation increases the real value of money and thus the real value of debt as well. Deflation makes it more difficult for borrowers to pay off their debts, meaning that consumers and firms will have to spend a bigger percentage of their disposable income on meeting debt repayments. This can reduce both consumption and investment and thus growth too.
