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
📦 1. Basket doesn’t reflect everyone’s spending habits
→ CPI is based on an average basket of goods and services
→ But not all households buy the same things (e.g. students vs pensioners)
→ So inflation experienced by different groups may vary
→ This reduces the accuracy of CPI for policy targeting
🕰️ 2. Slow to reflect changes in consumption patterns
→ Consumer habits evolve over time (e.g. streaming over DVDs)
→ But CPI baskets are only updated annually
→ This time lag can cause the index to misrepresent real inflation
→ Especially during rapid tech or lifestyle changes
🛍️ 3. Doesn’t account for quality improvements
→ Prices may rise because products improve (e.g. faster phones, safer cars)
→ CPI records this as inflation, even if value-for-money rises
→ This leads to an overestimation of “real” inflation
→ Especially problematic for long-term trend analysis
🌍 4. Excludes housing costs (in UK CPI)
→ CPI excludes major costs like mortgage interest or house prices
→ Housing is a significant part of household spending
→ This omission means CPI can underestimate cost-of-living pressures
→ Leading to misleading conclusions in high house-price economies
💡 5. Substitution bias
→ If the price of one good rises, consumers might switch to cheaper alternatives
→ But CPI assumes a fixed basket of goods
→ This fails to reflect how consumers really respond to price changes
→ Causing CPI to overstate inflation
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
- Erodes Purchasing Power → High inflation reduces the real value of money → Consumers can buy fewer goods/services with the same income → This reduces real incomes, especially harming those on fixed incomes → Leading to lower living standards.
- Creates Uncertainty →
Firms and consumers struggle to plan for the future → Investment and long-term contracts become riskier → Reduced capital investment and consumer confidence → Slower long-run economic growth. - Harms International Competitiveness →
If UK inflation is higher than trading partners → UK exports become relatively more expensive → Demand for UK goods falls while imports rise → Worsening of the current account balance. - Menu Costs →
Firms must constantly change prices due to frequent inflation → Reprinting menus, updating systems, and re-labelling → Increases operational costs and wastes time → Reduces firm efficiency. - Shoe Leather Costs →
With inflation, people try to avoid holding cash → They make more frequent trips to the bank to withdraw money → Wastes time and increases inconvenience → Reduces productivity. - Income Redistribution Problems →
Inflation can redistribute income unfairly → Borrowers gain as they repay with money worth less → Savers and those on fixed incomes lose out → Increased inequality and reduced trust in the economy.
benefits on inflation
🔼 Moderate Inflation Can Encourage Spending
➡️ Households and firms expect prices to rise in the future
➡️ So they bring forward consumption and investment
➡️ This increases aggregate demand and economic growth
➡️ Helps reduce unemployment in the short run
💷 Erodes Real Value of Debt
➡️ Inflation reduces the real value of fixed repayments
➡️ Governments and individuals with high debt benefit
➡️ Encourages borrowing and investment
➡️ Helps reduce the debt-to-GDP ratio over time
🧰 Provides Monetary Policy Flexibility
➡️ Some inflation allows central banks to use interest rates more effectively
➡️ If inflation is too low or negative, central banks have less room to cut rates
➡️ Moderate inflation avoids the risk of deflation
➡️ Helps maintain price stability and growth
📈 Indicates Growing Economy
➡️ Rising prices may signal increased demand in the economy
➡️ This can incentivise businesses to invest and expand
➡️ Leads to job creation and increased incomes
➡️ Supports long-term development
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
benefits of deflation
🛍️ 1. Increased purchasing power of money
→ Falling prices mean consumers can buy more with the same income
→ Real incomes rise, especially for those on fixed incomes or pensions
→ Consumption may increase, particularly for essential goods
→ Higher living standards and improved real welfare
📉 2. Incentives to cut costs and innovate
→ Firms experience price pressure in deflationary environments
→ To maintain profit margins, they invest in efficiency and innovation
→ This can lead to long-term productivity gains
→ Supports international competitiveness and future growth
🇬🇧 3. Strengthens the currency
→ Lower prices often reflect a stronger currency or rising productivity
→ Imports become cheaper, reducing cost-push inflation
→ Improves current account position if exports remain stable
→ Can increase consumer confidence in the economy
🏦 4. Low or benign deflation may follow positive supply-side shocks
→ For example, technological improvements reduce costs of production
→ Leads to lower prices but also higher output
→ Unlike demand-deficient deflation, this is growth-friendly
→ Associated with rising real GDP and falling unemployment
Narrows the gap between rich and poor. As deflation causes a decrease in the value of financial assets, it becomes very hard for citizens to accumulate wealth. This will hit many rich people who tend to hold more wealth-building assets such as apartments, houses, office buildings, land, businesses, etc. as compared to poor people.
production workers will not be asking for higher wages because now they will be able to buy more products with the same amount of money, as their money is gaining value. Deflation will lead to lower Variable Costs (VC) that decrease the cost of production, or Cost of Goods Sold (COGS), therefore increase Gross Profit.
