Inflation

Question 1

Define Inflation

Answer 1

The general and sustained rise in the price level in an economy over a given period of time.

Question 2

Define Deflation

Answer 2

The general and sustained fall in the price level in an economy over a given period of time.

Question 3

Define Disinflation

Answer 3

The slowing down in the rate of inflation.

Question 4

Index number formula

Answer 4

% change + 100 (base year)

Question 5

Define Consumer Price Index

Answer 5

CPI is the preferred measure of inflation by the Government, using the change in price level of a basket of goods to determine inflation. The basket’s items are weighted depending on the proportion of household income spent on each category (food, drink, transport, footwear, etc)

Question 6

Define Retail Price Index

Answer 6

RPI measures inflation through monitoring the change in average price based on a basket of goods. RPI accounts for both mortgage payments and council tax, which means that it will always show a higher rate of inflation compared to CPI.

Question 7

What are the 3 limitations of CPI?

Answer 7

1) It does not account for all production and consumption within an economy.
2) Does not account for substitutes, with consumers likely switching to alternative products as prices rise.
3) Does not account for mortgage repayments.

Question 8

What are the three main causes of inflation?

Answer 8

Demand-pull, cost push, growth of the money supply

Question 9

Cost-push inflation occurs due to a rise in costs. What 5 key factors lead to a rise in costs and why?

Answer 9

1) An increase in wages: increases a firm’s costs of production, resulting in a higher price being charged to maintain profit margins.
2) Profits: A firm may up their prices to maximise profits, depending on the product’s elasticity.
3) Government intervention: By imposing a higher tax on profits, firms may up their prices to retain their previous levels of profit.
4) An increase in commodity prices: Costs of production increase for a firm, causing them to increase prices. E.g. Ukraine War increased oil prices
5) A fall in the value of the exchange rate: Imports become more expensive for firms, increasing their costs of production, causing them to raise prices.

Question 10

Demand-pull inflation occurs when there is excess demand in the economy, with producers unable to raise supply to meet the new demand in time. What 5 factors could cause this and why?

Answer 10

1) A sharp rise in consumer spending: consumption is the largest component of Aggregate Demand, so an increase in consumption causes a rise in AD.
2) An increase in investment by firms: Investment is a component of AD, so an increase in investment will cause a rise in AD.
3) An increase in government spending: Government spending is a component of AD, so by increasing government spending, AD will rise.
4) Tax cuts: Consumers will see more disposable income, increasing their consumption, the largest component of AD, so if consumption increases, then so will AD.
5) An increase in demand for UK exports: Net trade (exports - imports), a component of AD, will increase if exports increase, causing a rise in AD.

Question 11

What is the money supply?

Answer 11

The stock of currency (cash, coins, bank account balances, etc) circulating in an economy

Question 12

How would a growth in the money supply cause inflation?

Answer 12

An increase in the money supply lowers interest rates (as the availability of money is higher, so the cost of borrowing is lower), incentivising borrowing and disincentivising saving, increasing consumption and investment, two components of AD. This increase in AD will cause demand-pull inflation.

Question 13

What is the Bank of England’s inflation target?

Answer 13

2%

Question 14

How does high inflation effect firms and workers (3)?

Answer 14

1) A high rate of inflation makes it hard for firms to plan expenditure, making them less likely to take risks and invest, resulting in an unstable market.
2) A firm’s costs of production will increase, leading to them cutting down on workers in order to maintain their profit margins.
3) Workers may also demand higher wages to keep up with inflation, raising production costs further for firms, which they may pass on to consumers.

Question 15

How does high inflation effect the government?

Answer 15

The balance of payments is affected if prices are rising faster than other countries. This also makes exports less competitive, as goods become more expensive to foreign nations.

Question 16

How does high inflation effect consumers (4)?

Answer 16

1) Leads to uncertainty and a lack of confidence to spend.
2) Savings are devalued.
3) Consumers are less likely to know what a reasonable price for a given good/service is anymore, causing them to shop around more for the best prices.
4) As the currency is worth less, consumers will spend more on the same product if their wage does not adjust to inflation.

Question 17

Define hyperinflation

Answer 17

Inflation at a very high rate. Examples include Zimbabwe in 2007 and Germany in 1923.

Question 18

What are the impacts of deflation (4)?

Answer 18

1) Falling prices cause low consumer confidence with the knock-on effect of low business confidence due to a fall in sales.
2) The real cost of borrowing rises despite interest rates being low, if debt rates are fixed.
3) A fall in the value of assets, especially savings.
4) Can cause an economic depression.