Inflation Flashcards
what is inflation
- a sustained increase in the average price level
- Fall in purchasing power of money/currency
what is disinflation
when prices are rising, but at a slower rate than before
what is deflation
a sustained fall in the average price level
how to work out index number
raw number / base year raw number x 100
how to work out annual inflation rate
work out percentage change of index numbers
percentage change equation
change divided by original x 100
what is the RPI
- alternative measure of inflation
- same as the CPI, but housing costs are included
- also calculated using an arithmetic mean, whilst CPU uses geometric mean, so the RPI will give higher measures
problems with using CPI
- CPI focuses on consumer goods and services and does not include asset prices such as housing, stocks, and bonds, which can lead to an incomplete picture of overall inflation and economic health.
- CPI assumes consumers do not change their spending patterns in response to price changes, leading to a potential overestimation of inflation due to substitution effects
- CPI may not accurately represent the spending habits of all demographic groups, especially if certain goods or services are underrepresented in the basket, sample size too low, only 650
- CPI measures exclude significant costs like house prices and instead focus on rental equivalents. This methodology underrepresents the impact of rising housing prices, especially in markets where property values are a significant component of living costs, making the index less representative of actual inflation trend
what is core CPI
the CPI minus price inelastic goods like food, energy
when would we use PPI(producer price index)
if we think that changes in energy prices would affect CPI in the future
when does demand pull inflation occur
when demand shifts to the right, increase in economic growth but increase in demand pull inflationary pressure
why does demand pull inflationary pressure occur
- when AD shifts to the right, there is greater pressure on existing factors of production to produce more output, resources/supply of them are becoming scarcer, so prices of these scarce resources are going up
things that’ll shift AD right
- decrease IR
- decrease income or corporation tax
- increased consumer business confidence
- increased govt spending
- weak exchange rate
when does cost push inflation occur
when SRAS shifts to the left
why does cost push inflation occur
- leftward shifts of SRAS mean that cost of production for firms will increase, so they’ll be passing those higher costs onto consumers in the form of higher prices
when does SRAS shift to the left
- increase raw material prices
- increased wages
- increased business taxes like VAT
- increased price of imported raw materials due to a weaker exchange rate
costs of high inflation
- loss of purchasing power for households and workers in the economy - assuming that wages and incomes are not rising with inflation, households and workers are worse off, can reduce their ability to buy basic goods and services, can push those on lower incomes into poverty
- erosion of savings - if interest rates are not rising in line with inflation, savings lose value, bad for those who rely on savings, eg unemployed or pensioners, also reduces MPS, bad for long term health of economy
- lower export competitiveness- if inflation is high in one country compared to another, exports are gonna be less internationally competitive, reducing demand for exports and revenue from exports and worsening the current account position, very bad for trade reliant countries
- wage/consumer price spirals - risk of hyperinflation- higher inflation rates, workers will bargain for higher wages, if firms allow this, their cost of production will increase, who will pass on higher costs as higher prices, increasing inflation, workers will then ask for even higher prices etc
- rational consumers buy more to save for the future, increase consumption, increase AD and push up demand pull inflation
- menu costs - increased prices means firms have to print more menus, new price catalogs, which is costly for them and they pass on these costs
- fiscal drag - when inflation is rising, workers are receiving higher incomes but only in line with inflation, workers not actually better off, but they still get put into higher tax bands, paying more income tax, living standards will decrease, but good for govt as they receive a tax revenue windfall (assumption that progressive income tax doesn’t rise in line w inflation)
- inflationary noise - when inflation rates are volatile (rise plateau, rise plateau), ppl start to lose understanding of what’s happening with price and why, uncertainty in economy, causes consumers to reduce consumption and firms to reduce long term investment
benefits on inflation
- workers can bargain for higher wages, even if all they get is an inflation equal price
- consumption is natural with low and stable inflation - consumers buy goods and services when they need to
- firms are encouraged to increase output if inflation is low and stable because they know they can raise their prices and earn more revenue
- small inflation means that unemployment stays low in a recession- in recessions, firms more likely to sack workers as revenue is falling, but its hard for firms to do this, dont wanna lose skilled workers - so firms can raise their prices in line with inflation, and get an increase in revenue, and can increase workers pay by a smaller percentage than inflation rate
- reduces real value of debt - always a fixed value, so if wages, revenue etc are rising, it’s easier to service debt
- inflation can improve the state of govt finances - govt get a fiscal windfall during inflation - as taxes rise, govt gets more revenue - govt may not always be spending that much on public goods and services
evaluation points on the costs and benefits of inflation
- rate - in low and stable inflation, tends to be more benefits than costs vice versa
- cause - demand pull inflation is more favourable than cost push - with demand pull, theres higher growth, lower unemployment, but a cost push, higher unemployment and lower growth, demand pull also easier to fix with contractionary demand side policies
- duration - long term high rates of inflation can become anticipated and spiral out of control
what is demand side deflation and features of it
- AD shifts left, reduction in price level, lower economic growth, we assume that the deflation could be long term and anticipated,
features of supply side deflation
- SRAS shifts to the right, reduction in PL, but comes with higher growth and short term unanticipated (not rlly gonna last)
why is anticipated deflation bad
- deflationary spiral
- rational consumers may delay spending, why buy now when prices will decrease more later?, but this is bad for the economy because consumption will fall, causing a fall in AD, which would encourage firms to reduce prices further, making deflation worse
- when AD falls, there is lower growth and higher unemployment
- real interest rates will always be positive because deflation is negative, so we will always be adding to the nominal rate, higher IR increases MPS, lower consumption, lower AD, higher deflation
- increases real value of debt - prices falling means that profits and incomes will also fall, as firms will be making less revenue and debt is always fixed, and lower incomes make it harder to pay off debts
what are real interest rates
nominal interest rates - inflation rate
why is short term (unanticipated) deflation beneficial
- falling prices for consumers
- falling input prices for firms
what policies could be used to bring down demand pull inflation
- contractionary demand side policies(monetary or fiscal), eg a cut in govt spending or an increase in tax
evaluation points for policies which could be used to target inflation
- trade offs with objectives - demand pull inflation may come down but may lead to lower economic growth and higher unemployment (could be a recession)
- impact on investment - higher interest rates detract investment, increases the cost of borrowing for firms, bad for short and long run growth, lower productivity, worsening of the competitiveness of the economy
- impact on the indebted - higher IR will have a negative impact on those who owe debt, could go bankrupt and living standards may suffer, if businesses go bankrupt, u employment may occur
- stronger exchange rate - higher IR could strengthen exchange rate and could widen a current account deficit, could lead to hot money inflows into the economy
why is monetary policy more suitable to target inflation
the monetary policy transmission mechanism has got a variety of avenues where interest rates changes can feed through into the economy
what is hot money
savings that chase the interest rate, eg if interest rates are relatively high in one country, savers from one country will move their money to that country, increasing the demand of the currency in the country they moved the money to
how to reduce cost push inflation (shifts in SRAS)
mproved Supply-Side Policies
Governments can implement supply-side policies like deregulation, tax cuts for businesses, and grants for innovation to reduce production costs.
For example, reducing corporate taxes may lower the cost base for firms, enabling them to absorb input price increases without raising prices.
This increases short-run aggregate supply (SRAS), reducing inflationary pressures while supporting economic growth.
Subsidies for Key Industries
Subsidies to industries that produce essential goods, such as energy or agriculture, can help offset rising input costs.
For instance, during energy crises, subsidies for power generation companies can prevent significant increases in energy prices for businesses.
By stabilizing costs, this policy reduces inflationary pressures, particularly for cost-sensitive industries.
intervene in FOREX markets to strengthen the exchange rate, as a stronger exchange rate makes imports cheaper, which would reduce the price of imported raw materials, reduce costs of production for firms who import raw materials
evaluation points for reducing cost push inflation
- increasing subsidies or cutting VAT has a significant government cost and may worsen govt finances
- intervention in forex not very smart as many countries have free floating exchange rates
- cost push inflation is usually short term, eg costs of raw materials dont usually stay high for a long time, don’t need to worry abt them as much
- can’t really do anything abt them, so shouldn’t really worry
how to reduce high long term inflation rates
- supply side policies, to increase the productive capacity of the economy and long run rates of economic growth, and reduce the amount of pressure thats on factors of production consistently (interventionist or market based)
-
evaluation for helping high long term inflation rates
1). no guarantee of success
2) costs - risk of wasteful spending/high oppurtunity cost
3) negative stakeholder impact
4) time lags
- depends on type of inflation
- rate of inflation, if inflation is around 2% we dont need to do anything
what is the price level
the average of the current prices of goods and services in the economy
explain the process of using the CPI
- households take the household expenditure survey
- A representative basket of goods and services used by average households is recorded
- Items are weighted according to proportion of spending on each product
- inflation rate measures change in average prices in an economy over a year
when the pound gets weaker, whys there increased inflation
- A weaker pound makes imports more expensive since it takes more pounds to purchase the same amount of foreign currency. This increases the cost of imported goods and raw materials
- A weaker pound makes exports cheaper for foreign buyers, leading to increased demand for British goods and services abroad. This rise in demand can put pressure on domestic production capacity, leading to increased prices.
Interest rates and inflation
- interest rates usually increase when theres high inflation to incentivise saving
- as interest rates rise,debt holders repayments increase
- leaves them w lower disposable income
impacts of deflationary spiral
- As consumers delay spending, overall demand for goods and services falls.
- With reduced consumption, businesses experience lower sales and profits, leading to cuts in production, wages, and employment(derived demand). Investment spending also declines, as firms hold back on expanding in a low-demand environment
- Lower consumption and investment reduce AD, potentially triggering further deflation and economic stagnation, as businesses face ongoing demand-side pressure.
