Inflation

Question 1

Define CPI

Answer 1

A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households.

Question 2

Define RPI

Answer 2

Similar to CPI but includes household mortgage interest payments and excludes very high and low income households

Question 3

Define RPIX

Answer 3

Similar to RPI but it excludes mortgage interest costs

Question 4

Define RPIY

Answer 4

The RPIY measures core inflation this is RPIX minus taxes such as VAT and excise duty

Question 5

Define Cost Push Inflation

Answer 5

occurs when we experience rising prices due to higher costs of production and higher costs of raw materials, it is determined by supply side factors (shifts SRAS)

Question 6

What are the causes of cost push inflation

Answer 6

Higher price of commodities such as oil as this will affect all firms’ costs.

Increased cost of imports due to a depreciation of the exchange rate.

Higher wages, such as if in a wage price spiral.

Higher taxes, such as VAT or excise duties.

Monopoly abuse, if a firm has increased power, it may increase prices.

Question 7

What are the policies to reduce cost push inflation

Answer 7

The government could pursue deflationary fiscal policy (higher taxes, lower spending) or monetary authorities could increase interest rates. This would increase the cost of borrowing and reduce consumer spending and investment.

The long-term solution to cost-push inflation could be better supply-side policies which help to increase productivity and shift the AS curve to the right.

Question 8

Define Demand pull inflation

Answer 8

A period of inflation which arises from rapid growth in aggregate demand, if AD rises faster than LRAS then firms will respond by putting up prices.

Question 9

What are the causes of demand pull inflation

Answer 9

Lower interest rates, causes a rise in AD.

A rise in house prices, creates wealth effect which boosts spending

Rising real wages

Question 10

What are the policies to reduce demand pull inflation

Answer 10

Fiscal policy – If AD is too high they may tighten fiscal policy by reducing gov spending on public and merit goods, or to raise direct taxes leading to a fall in AD.

Monetary Policy – Increasing interest rates to increase saving not spending and reduces the houses demanded as higher mortgage rates

Supply side policies to increase productivity, competition which will lead to lower prices.

Question 11

What do monetarist economists argue

Answer 11

Monetarists (Milton Friedman) argue that if the money supply rises faster than the rate of growth of national income, then there will be inflation.

Question 12

What is the Fischer Equation

Answer 12

Fischer version MV=PT or MV=PY

M = money supply

V = Velocity of circulation (is the average number of times the dollar is spent

P = Price level

T = Transactions

Y = Real GDP

Question 13

How do you make nominal GDP with the Fischer equation

Answer 13

So P x Y or M x V = nominal GDP (given in current prices, without adjustment for inflation.)

Question 14

How does an increase in money supply cause inflation

Answer 14

Monetarists believe that in the short-term velocity (V) is fixed. This is because the rate at which money circulates is determined by institutional factors, e.g how often workers are paid does not change much but is treated as fixed.

They also believe output Y is fixed. They state it may vary in the short run by not in the long run (because LRAS is inelastic and determined by supply side factors).

There is only 1 point left M that can increase P.

Question 15

What is the critics of monetarism

Answer 15

V – is not very stable due to confidence

The link between Money supply and Inflation is very weak.

An increase in money supply would take around 9-12 months to lead to higher output.

Question 16

Define Transmission mechanism

Answer 16

This is the process through which monetary policy decisions affect the economy in general and the price level in particular. The transmission mechanism is characterised by long, variable and uncertain time lags.

Question 17

How does an increase in interest rates affect the transmission mechanism

Answer 17

Will decrease the prices of market rates, asset prices, reduce confidence and appreciate the pound. The appreciation will cause inflation as an increase in external exports but using the other channels which will overall decrease demand these will overpower the one channel and decrease inflation.

Question 18

Why does a rise in interest rates mean a fall in AD?

Answer 18

Higher Interest rates discourage spending and encourages savings

The exchange rate tends to rise making exports and imports less competitive.

Firms spend less on investments as fewer investment projects remain profitable.

Question 19

Why have some economists argued that monetary policy should be administered by an independent central bank

Answer 19

Because some governments are reluctant to change interest rates if there is an important election upcoming. Independent banks have the aim to reduce inflation nothing else

Against this view as this distorts government policy and places a too high value on inflation.

Question 20

Give me an example of wage price spirals

Answer 20

an example being wage push spirals, when workers press for wage increases which are equal or above the rate of inflation.

Question 21

What happens when wages increase

Answer 21

As wages increase, so does a consumer’s propensity to both save and consume.

Question 22

What happens when minimum wage increases

Answer 22

If the minimum wage increases, consumers within the economy will purchase more products, which would increase demand. The rise in aggregate demand.

Question 23

How to end a wage price spiral

Answer 23

Wages are linked to productivity growth. If wages rise 10%, but productivity is also 10%, then firms can afford to pay higher wages without passing the cost increases on to consumers.

Monetary policy. The government/Central Bank can decide to tackle inflationary pressures using the monetary policy. For example, an increase in interest rates increases cost of borrowing/mortgages and will reduce disposable income, causing workers to hold back from spending.

Cost-push inflation falls. A rise in oil prices may cause a spike in inflation, but this will be temporary, if oil prices fall, then cost-push inflation will also fall, causing less pressure for wage increases.