Inflation

Question 1

What is CPI (consumer price index)?

Answer 1

An index based on the average price of a basket of goods/services commonly consumed by British households.

Question 2

How do you calculate CPI?

Answer 2

Cost of the market basket in a given year / cost of the market basket in the base year.

Question 3

What are does the basket consist of?

Answer 3

• Utility bills
• Healthcare
• Education
• Food

Question 4

How do you calculate inflation?

Answer 4

Difference between CPI’s (non-base years) / original CPI.

Question 5

Cons of Inflation?

Answer 5

1) Lower Purchasing Power (affects living standard) (regressive for poorer households)

2) Erosion of savings (interest rates don’t necessarily reflect inflation) = affects pensioners.
- “Shoe leather costs”
- “Menu Costs”
Less incentive to save = less loanable funds = savings gap.

3) Lower Export competitiveness = (causing account deficit) = (decreasing growth)

4) Wage / Consumer “ Wige/Price Spirals”

5) Business uncertainty: High and volatile inflation is not good for confidence partly because business cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a fall in capital investment.

Question 6

Pros of Inflation?

Answer 6

1) Workers can bargain for higher wages. = (boost morale + productivity)

2) Consumption is natural

3) Firm encourages increased output, due to the profit incentive.

4) Reduces the value of debt. If firms have debt, then inflation may help reduce the real value of debt. This is because nominal revenue will rise under inflation – making it easier to pay off old loans.

5) Improvement of Gov. finances - increase in VAT rev and Tax (more ppl in tax bands after wage demand).

Question 7

Consequences of deflation?

Answer 7

Costs:

1) Delayed expenditure - falling prices causes consumers to delay large expenditures and businesses to delay investment, reducing AD and prices further, possibly leading to a deflationary spiral.

2) Firms may cut wages in an effort to cut costs and maintain profit margins in the face of falling prices.

3) During periods of deflation, money is increasing in value over time in terms of what it can buy, encouraging saving over spending. To encourage spending central banks will need to cut interest rates, but even on interest rate of 0% when inflation is at -3% leads to a “real interest rate” of 3%. Hence, interest rates lose their usefulness as a monetary tool.

4) Deflation increases the value of real debt leading to a negative wealth effect, discouraging spending further. This also increases the value of National Debt for the government.

Question 8

Wage Spirals?

Answer 8

Employees ask for higher wages to battle higher living costs —> inflation —> employees once again asking for higher wages —> higher inflation, and it repeats.

Question 9

Consumer-Price spiral?

Answer 9

Consumer anticipate higher prices in the furniture —> increase expenditure now —> further inflation.