Inflation Flashcards
Inflation definition
Inflation is the general increase of prices in an economy which erodes the purchasing power of money. Low inflation is generally considered to be better than high inflation.
Deflation definition
Deflation is the fall of prices and indicates a slowdown in the rate of growth of output in the economy .
Disinflation definition
Disinflation is a reduction in the rate of inflation ie prices are still rising but they are not rising by as much.
Indices
Nominal figures must be changed into real figures to make comparisons. This is done by choosing one year for the base year and adjusting all other figures into equivalent figures. In Britain, the most well-known indices are the retail price index (RPI) and the consumer price index (CPI). The base figure is given an index number of 100 and all the figures before or after that time are then compared to that figure.
Consumers price index (CPI)
-The Office for National Statistics (ONS) collects prices on 710 goods and services from 20,000 shops in 141 locations and online sites and the prices are updated every month, with collectors visiting the same retailers to monitor identical goods. New items are added to the list every year, such as microwaveable rice and nail varnish, whilst others are taken away, including organic carrots.
-All these prices are combined using information on the average household spending pattern to produce an overall price index. The average household spending is worked out through the living costs and food survey, where around 5,500 families keep diaries of what they spend over a fortnight.
-It takes into account how much is spent on each item so they are weighted ie we spend more on petrol than on postage stamps so an increase in petrol will have a bigger impact on the overall rate of inflation.
Limitations of CPI
-It is impossible for the figure to take into account every single good that is sold in the country and so therefore the CPI is not totally representative. Similarly different households spend different amounts on each good and so therefore the CPI only measures an average rate of inflation, and is not totally representative.
-Moreover, it doesn’t include the price of housing and so, since this has tended to rise more than the price of other goods, the data may be lower than it should be.
-Since the figure is more recent than RPI, it is difficult to make comparisons with historical data. It was only used since 1996 with estimates going back to 1988 which means that levels of inflation using CPI can only be accurately compared back to then.
Some people argue that all inflation indices overestimate inflation because they don’t take into account the fact that goods and services have improved in quality, and so will obviously be more expensive. For example a car in the 1950s would be far less comfortable and reliable that todays. It has no way of indicating the change of goods that is bought.
Retail price index (RPI)
Very similar to CPI, however there are some differences between the data included and the way it is calculated.
-RPI includes housing costs such as mortgage and interest payments and council tax, whereas CPI doesn’t.
-CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore the CPI is generally lower than the RPI.
-RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes
RPI is no longer considered as the best method and has had its national statistic status removed, although the Office for National Statistics still calculates it every month.
Causes of inflation: demand pull
-prices in a market are determined by demand and supply and a shift in either will cause price to change. Inflation can therefore be caused by an increase in aggregate demand (AD), total demand for goods and services in the economy.
-If any factor which increases AD was to increase, then inflation would increase.
Causes of inflation: Cost push
-whilst an increase in aggregate demand can push prices up, a decrease in aggregate supply may also push prices up.
-When businesses find their costs have risen, they will put up prices to maintain their profit margins. This can be caused by any factor which decreases AS.
Causes of inflation: growth of money supply
-Too much money in the economy. If people have access to money they will want to spend it but if there is no increase in the amount of goods and services supplied, then prices will have to rise.
-The government can also increase the amount of money that they print and decisions to increase government borrowing can also increase the money supply.
Effects of inflation on consumers
-If people’s incomes don’t rise with inflation then they will have less to spend, which would cause a fall in living standards.
-Those who are in debt will be able to pay it off at a price which is of cheaper value, but those who are owed money lose because the money they get back is of cheaper value. Consumers who have saved will lose out as their money is worth less.
-Inflation has psychological effects on consumers: because prices are rising, they may feel less well-off, even if their income is rising in line with inflation, and so this may cause them to decrease their spending.
Effect on firms of inflation rise
-If inflation in Britain is higher than other countries, British goods will be more expensive. They will become less competitive and make them more difficult to export. This will also affect the balance of payments.
-Deflation isn’t good as it encourages people to postpone their purchases as they wait for further price fall. People will be more likely to save as the value of their money will rise in the future and they will be prevented from borrowing as deflation means the real value of their debt increases. This can lead to a fall in demand for goods, leading to a fall in firms profit, and in business confidence which can lead to a long term reluctance to invest.
-In general, inflation/deflation/ disinflation is difficult to predict and so this means that firms cannot plan for the future.
-Another effect of changing prices is that firms will have to calculate new prices then change their menus, labelling etc. and this can be expensive.
Effect of government of inflation rise
-If the government fails to change excise taxes (taxes at a set amount eg £1) in line with inflation then real government revenue will fall. However, if they fail to change personal income tax allowances (the amount a worker can earn tax free) then real government income will increase and taxpayers will have less money.
Effect of workers of inflation rise
-If workers don’t receive yearly pay rises of the rate of inflation, they will be worse off and their living standard will decrease. Those in weaker unions tend to be most affected as they are unable to win wage rises in line with inflation.
-deflation could cause some staff to lose their jobs as there is a lack of demand and firms see a fall in profit and have to decrease staff to cut costs.
Indexation
Planning ahead for future inflation- workers asking for more- can cause further inflation - if inflation has been set at 10% previously but the government wants to reduce it to 2%, this will be difficult if workers are still getting a 10% pay rise due to indexation agreements.
