Inflation

Question 1

what is inflation?

Answer 1

Def: An increase in the general price level of goods and services. Measured as a percentage of GDP.

Question 2

how is it measured?

Answer 2

We calculate inflation using a weighted basket of goods which is ‘purchased’ every month and compare the cost of the basket monthly to work out inflation rates.

Question 3

what are the different baskets?

Answer 3

There are two very similar baskets – almost identical. They’re different because RPI includes mortgages and/or rent and thus the CPI was created so that the housing market did not distort the RPI.

1. The Consumer Price Index
2. The Retail Price Index

Question 4

what are the two causes of inflation?

Answer 4

demand pull inflation (an increase shift in demand) and cost push inflation (a reduction in aggregate supply.)

Question 5

what are the consequences of inflation?

Answer 5

1. Erodes standard of living - If wages are constant and prices rise, then income is less significant as less items can be bought with the same amount of money and thus your standard of living is lower. However, wages can also increase. E.g. +2% on wages is a nominal increase in income. However, if inflation is at a rate of 3%, there is a – 1% change in real income. This shows that wages must as least grow at the same rate as prices in order to not erode standard of living.
2. Loss of international competitiveness – prices rising in the UK cause imports to become more attractive and exports much less attractive.
3. Inflation causes a reduction in business confidence, this sometimes known as inflationary noise (constantly changing prices affecting business confidence due to the lack of certainty.
4. People that rely on benefits including most pensions are vulnerable to inflation as it is uncommon that they are credited for an increase in inflation.
5. Savers lose out – money becomes worth less, so it encourages spending. However, saves do need to take into account the real interest rate due to the difference between nominal and real rates. E.g. if inflation is 3% and the interest rate is 1.4% (a nominal figure,) the real interest rate is actually -1.6%
6. Menu costs – the cost of reprinting and relabelling all items due to the changes in pricing caused by inflation. Affects time and money.
7. Wage price spiral ? – not necessarily going to happen. Inflation means that workers are more likely to request a pay rise which causes firms to increase costs. Because of this, prices rise due to cost push inflation, and people ask for a raise. Hence the term spiral.
8. Shoe leather costs – the idea that there is time and money wasted in searching for the best price within a competitive market where prices are always changing. Not as relevant in modern days due to the internet and online catalogues.