Inflation

Question 1

What is inflation?

Answer 1

a sustained increase in the general price level

Question 2

What is deflation?

Answer 2

a sustained decrease in the general price level.

Question 3

What is disinflation?

Answer 3

a reduction in the rate of inflation (the inflation rate falls but the price level is still rising, but at a slower rate).

Question 4

What is cost-of-living?

Answer 4

a measure of changes in the average cost for a household of buying a basket of different goods and services.

Question 5

What is the inflation target?

Answer 5

a target set by the government which the central bank should aim to achieve eg in UK it is CPI inflation = 2% +/- 1% point

Question 6

What is the Consumer Price Index?

Answer 6

The ‘headline’ rate of inflation is the annual % change in the CPI. The CPI tracks changes in the prices of a basket of goods and services purchased by an average household.

Question 7

What is the CPI inflation formula?

Answer 7

CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100

Question 8

What is basket of goods and services?

Answer 8

things a typical household buys; updated each year to keep it relevant

Question 9

What is the price survey?

Answer 9

prices of the goods and services in the basket are monitored each month. The price of each representative good/service in the basket is weighted according to the proportion of income a typical household spends on it

Question 10

What is CPIH?

Answer 10

similar to CPI but also monitors owner occupier housing costs (OOH),in its basket. These are the costs associated with owning, maintaining and living in one’s own home.

Question 11

What is RPI (Retail Price Index)?

Answer 11

the basket of goods/services includes some items not in the CPI, such as council tax & mortgage interest payments; it is often used to calculate increases in welfare benefits, pensions, index-linked bonds and wage negotiations; in a period of rising interest rates it typically gives a higher rate of inflation than the CPI

Question 12

What is “core” inflation?

Answer 12

sustained increase in prices of goods in the basket, excluding goods suchas energy, food, alcohol and tobacco which can have volatile prices.

Question 13

What are limitations of the CPI inflation measure?

Answer 13

• CPI inflation is only calculated for an ‘average’ family
• It does not consider quality of goods/services
• Needs regular updating to reflect changes in patterns of spending
• International comparisons may not be accurate if other countries do not calculate inflation in the same way

Question 14

What are costs of inflation?

Answer 14

• Shoe leather costs
• Menu costs
• Fall in real incomes
• Uncertainty
• Redistributional effects
• Loss of international competitiveness
• Increase in inflation expectations
• Danger of wage-price spiral

Question 15

What are shoe leather costs?

Answer 15

costs of shopping around when prices change rapidly

Question 16

What are menu costs?

Answer 16

costs of redoing menus, parking changes, price labels & lists

Question 17

What is fall in real incomes?

Answer 17

if wages do not keep pace with prices, real incomes fall

Question 18

What is uncertainty?

Answer 18

consumers and businesses may reduce their spending causing unemployment and weaker growth

Question 19

What are redistributional effects associated with inflation?

Answer 19

savers get a lower real rate of return, those on fixed incomes lose out, workers in the gig economy may not be able to negotiate real wage increases; fiscal drag increase tax paid if thresholds are frozen

Question 20

What is a loss of international competitiveness from inflation?

Answer 20

weaker current account on the Balance of Payments as exports become relatively more expensive and imports relatively cheaper

Question 21

What is an increase in inflation expectations?

Answer 21

people will aim for bigger pay rises if they expect higher inflation, which can add to business costs and prices

Question 22

What is the danger of the wage price spiral?

Answer 22

if workers demand big pay rises

Question 23

What are benefits of a low rate of inflation?

Answer 23

• A low but steady rate implies aggregate demand is running ahead of aggregate supply, incentivising business investment and growth
• Reduces the real value of debt
• Allows negative interest rates
• Helps labour markets work more efficiently without a need to cut nominal wages because real wages can fall
• Makes malign deflation less likely

Question 24

What is demand pull inflation and show what it looks like?

Answer 24

Demand-pull inflation is inflation caused by excess AD in the economy.
Producers can raise prices and increase their profits
AD shifts right causing the price level to rise from PL1 to PL2

Question 25

What are **causes of demand pull inflation?**

Answer 25

* Lower interest rates * Lower income tax * Rapid income growth * High consumer confidence * Positive wealth effects * Easy credit (cheap and accessible credit) * Depreciation of the currency

Question 26

How can a **growth in the money supply** cause inflation?

Answer 26

Monetarists argue that inflation is caused by excessive growth of the money supply - 'too much money chasing too few goods’. Firms and consumers may spend their excess money, thus raising AD; the demand for labour could rise because it is derived from demand for goods increasing wages and costs of production.

Question 27

What is **cost push inflation** and what does it look like?

Answer 27

**Cost-push inflation** is inflation caused by increases in the costs of production in the economy. Can cause **stagflation** – when economy stagnates as price level rises **SRAS shifts left/up causing the price level to rise from PL1 to PL2**

Question 28

What are **causes of cost push inflation**?

Answer 28

* Rapid wage rises/higher labour costs * Skill shortages * Increasing input costs (raw material, energy) * Higher commodity prices * Food price inflation * Indirect tax rises * Depreciation of currency (imported inflation)

Question 29

What is the difference between **anticipated and unanticipated inflation?**

Answer 29

Inflation tends to be more damaging when is it unanticipated; the costs of inflation to economic agents are higher when there is an inflation shock eg a sudden sharp increase in energy or food prices. Having an inflation target, as is the case in the UK, can help with ‘inflationary expectations’ and ‘anchor’ inflation to the 2% target.

Question 30

What is **demand side deflation** and show what it looks like?

Answer 30

Deflation caused by fall in AD ie inflation caused by a lack ofAD in the economy. Producers have to reduceprices and their profits fall AD shifts left causing the price level to fall from PL1 to PL2; larger negative output gap

Question 31

What are costs of deflation?

Answer 31

* Lower AD causes over supply * Lower prices for goods and services cuts cash flow and profits for businesses; consumers may delay their spending; businesses may cut investment * Businesses reduce production; cyclical unemployment rises * Rise in real value of debt * Real interest rates may rise reducing consumption and investment

Question 32

What are **causes of "malign" deflation?**

Answer 32

* Negative demand shock (eg credit crunch in global financial crisis 2008-9) * Global recession * Appreciation of currency causing fall in net exports * Falling asset prices (negative wealth effect) * Contractionary fiscal and or monetary policy

Question 33

What is **supply side deflation** and what is it caused by?

Answer 33

**Deflation caused by an increase in short run aggregate supply** ie deflation caused by decreases in the costs of production in the economy; **SRAS shifts right causing the price level to fall from PL1 to PL2. LRAS could also shift right.**

Question 34

What are causes of **'benign' deflation?**

Answer 34

Technological advances Improvements in productivity Falling price of commodity prices Falling price of energy prices Globalisation/economies of scale Cheaper/more skilled labour (perhaps from immigration)

Question 35

What are benefits of deflation?

Answer 35

* Falling prices for consumers * Increase in real incomes * Increased spending power for those on fixed incomes * Improved international competitiveness * Falling asset prices make housing more affordable for first time buyers!