Inflation

Question 1

Define inflation

Answer 1

An increase in the average price level of goods and services in an economy as measured by the Consumer Price Index

Question 2

How does The Office of National Statistics (ONS) calculate the inflation rate?

Answer 2

• a sample of households is questioned to see what the average household spends money on in a typical month
• these goods and services are weighted to the proportion of income they typically take up
• from this a hypothetical basket of goods is created, the total cost of the basket is calculated using data from online and high street retailers
• the cost of the basket is recalculated in subsequent months/ years and put into index form to calculate the % change/ inflation rate

Question 3

What is demand-pull inflation?

Answer 3

• this is when there is excess demand in an economy/ AD moves outwards and exceeds the capacity of AS
• prices rise to ration demand and return the economy to equilibrium

Question 4

What could cause demand-pull inflation and what effect can the multiplier effect have?

Answer 4

• government cutting the income tax levels which gives households more disposable income
• the interest rates fall which incentivises credit-based spending and disincentivises saving
• the multiplier effect could create further shifts of AD which puts more upward pressure on prices

Question 5

What is cost-push inflation?

Answer 5

This is when an increase in the costs of production for firms means these costs are passed onto consumers in the form of higher prices.
This has to affect a wide range of sectors to have an aggregate impact (AS shifts left)

Question 6

What could cause cost-push inflation?

Answer 6

An increase in the price of land - natural resources such as the global price of oil

An increase in the cost of labour such as a higher minimum wage

A decrease in productivity

Question 7

What is the quantity theory of money and the Fisher equation?

Answer 7

The quantity theory of money states that inflation is caused by too much money being in the economy.
With no spare capacity, an increase in the money supply will lead to a proportionate increase in the price level.

Fisher equation: MV = PQ

M: money supply
V: velocity (the number of times the money changes hands)
P: average price level
Q: total number of transactions

V and Q are constant

Question 8

Explain how inflation causes a lower standard of living

Answer 8

Inflation means the real value of money declines and has less purchasing power, therefore households can access fewer goods and services which decreases living standards

This has a regressive effect: low income households will be worse off than high income households as low income households spend a greater proportion of their income on needs than wants so can’t cut back spending in other areas and won’t have savings

Question 9

Explain how inflation has a threat of further inflation

Answer 9

Inflation creates a ‘buy now’ mentality: consumers will spend immediately as they notice prices are rising. This creates more demand in the economy and more upward pressure on prices

Also workers will ask for wages higher than inflation so the real value of their wage doesn’t fall which can create a wage/price spiral - higher wages driving prices up

Can cause hyperinflation

Question 10

Explain inflation’s impact on savers

Answer 10

Inflation reduces real value of savings, if inflation rates are higher than interest rates then the real value of the savings will decrease, e.g. 3% interest rate with 5% inflation means the value of savings decreases by 2%

Savers suffer a fall in living standards and households are less incentivised to save which can create more inflation as they are incentivised to spend

Question 11

Explain inflation’s impact on businesses

Answer 11

Inflation increases costs of production e.g. increased cost of raw materials and labour as workers bid up their wages

Firms may pass the costs on to consumers with higher prices (cost-push inflation)

Inflation creates business uncertainty which delays investments and reduces productivity growth

Question 12

Explain inflation’s impact on government debt

Answer 12

When the government borrows to pay down a budget deficit they issue bonds with an annual interest rate. Some are index linked meaning the interest rate is linked to the rate of inflation.

Therefore if inflation rises then the government will need to pay more in debt servicing (25% of UK debt is index linked)

Opportunity cost - the money could’ve been spent elsewhere

Question 13

How can inflation be good? (Economic activity)

Answer 13

Some inflation shows an economy to be active and healthy so the target is 2% and not 0%.
The opposite alternative to inflation is deflation (price level decrease) which usually happens during a recession when there is insufficient demand

Price increases can incentivise firms to invest to take advantage of additional demand

Question 14

How can inflation be good? (Debts)

Answer 14

Inflation reduces the real value of debt - this applies to household’s debt (mortgages) firm’s debt (investments) and government’s debt (bonds)

Government receives more tax revenue if prices and wages are rising

Question 15

What are 3 policies the government can use to reduce inflation?

Answer 15

Supply-side policies, fiscal policy and monetary policy

Question 16

Explain how the government would use fiscal policy to reduce inflation

Answer 16

Fiscal policy is the use of tax and spending levels to achieve macro-economic goals.

The government could increase direct taxes, e.g. income taxes, so households have less disposable income and spend less (in the UK household consumption is the largest component of AD) AD shifts in reducing pressure on prices and reducing inflation

Government spending could be reduced to reduce AD as well as

Question 17

Why could fiscal policy be bad for inflation?

Answer 17

Increasing tax at a time when there is inflation may make people worse off, especially low income families

Also taxes and spending are likely to be used by governments for electoral advantage rather than economic necessity

Question 18

Explain how the government/ central bank could use monetary policy to reduce inflation

Answer 18

Monetary policy is the manipulation of the money supply to achieve macro-economic goals

If the base rate is increased commercial banks will offer more on interest payments on savings and charge more for borrowing

Firms and households are incentivised to save, they are disincentivises to engage in credit-based spending and debt repayments may increase so AD shifts left

Question 19

Why could monetary policy not work?

Answer 19

Large time lag, interest rate changes take up to 18 months to have a full impact - inflation may have run out of control before the impacts occur

High interest rates discourage investment by firms which has a long run effect of reducing productive efficiency

Question 20

Explain how the government would use supply-side policy to reduce inflation

Answer 20

Cost-push inflation cannot be reduced using demand management policies (monetary and fiscal) so supply/side policy has to be used

Supply-side policies can be used if higher production costs are caused by higher labour costs by labour being unproductive or labour shortages

Question 21

Why could supply-side policies not work for inflation?

Answer 21

Cost-push inflation can be caused by a rise in global commodity prices which the UK cannot do anything about

Large time lag to have an impact and have trade offs such as government debt - or can cause more inequality if free market policies such as reducing minimum wage are used