Inflation 2.1

Question 1

Inflation def.

Answer 1

The ongoing increase in the average price level of goods across the economy over a period of time

Question 2

Disinflation def.

Answer 2

A fall in the rate of inflation
e.g. goes from 4% in one year to 3% in the next.
DO NOT confuse with Deflation. In disinflation the price level is still rising, deflation it is falling

Question 3

How we measure inflation (Index Numbers)

Answer 3

A base year is selected (starting point) and each good from the Basket of Goods (representative of spending in the average UK household) is given an index number of 100. Prices are updated every month.

A weighting system is in place, which measures the percentage of household income is spent on the item. The ONS uses a system of weight that totals 1000, so in 2018-19 the average UK household spent 10.6% of their income on food and drink, thus the weight of food & drink would be 106

Question 4

Deflation

Answer 4

When prices are falling
This is harmful as it increases the real value of debt and real interest rates
Leads to the ‘Death Spiral’, where falling prices encourage households to stop spending in anticipation of future lower prices. This causes job losses and falling output. Happened in Japan in 1995 after a collapse in the housing market Boom, resulting in recession or low growth for almost 20 years (the lost decades)

Question 5

RPI

Answer 5

Like the CPI, but includes mortgage payments
Isnt used officially by the BoE to set inflation targets, mainly because it is heavily impacted by interest rates.
If interest rates rise, RPI will and vice versa, thus the Gov. target inflation of 2% is CPI

Question 6

Limitations of CPI

2

Answer 6

Doesn’t account for changes in quality, e.g. 10 years ago, mobile phones were cheaper, yet far lower quality than what we have now

Doesn’t factor in substitution (people may start buying cheaper goods as a substitute for those becoming more expensive). The CPI still assumes spending on these expensive goods is the same, which it isn’t

Question 7

Demand-Pull Inflation (u)

Answer 7

When aggregate demand cannot be met by an increase in aggregate supply.
Diagram

Question 8

Cost-Push Inflation (u)

Answer 8

Arises from rising costs of production
Diagram

Rising costs could be caused by:

• Rising commodity prices (oil)
• Increase in wages
• Fall in the exchange rate (imports more expensive)
• Indirect tax increases

Question 9

Central Bank inflation target and why?

Answer 9

2%

This is because it causes an optimistic climate - business see rising profits and sales, consumers see rising incomes

Question 10

Effects of inflation

4

Answer 10

International Competitiveness - High inflation in the UK makes goods more expensive to buy, causing a worsening in the Balance of Payments (difference in inflow and outflow into an economy)
Low competitiveness means a fall in output and thus higher unemployment. Policies to reduce inflation, such as higher interest rates, will reduce investment and spending (encourages saving)

If wages do not increase in line with inflation then falling real wages. This is a big issue for those on fixed incomes like state pensions

Shoe Leather Costs - harder for firms and consumers to find the best prices as they constantly are changing

Menu Costs - Cost of changing prices on menus, packaging etc. for firms

Redistribution of income - Reduces real value of savings, but reduces real value of debt, benefitting borrowers not savers.

Question 11

Effects of inflation on government

2

Answer 11

Gov. will raise more money from taxes if they do not increase the Income Tax personal Allowance (currently £12,500 if under £100,000 income)