Inflation (causes and problems)

Question 1

Define inflation (7)

Answer 1

Inflation – a general increase in prices and fall in the purchasing value of money, currently 2.4% and target is 2% +/- 1% according to the CPI measure of inflation set by the Bank of England and maintained by the monetary policy committee.

Question 2

How is intentionally caused? (2)

Answer 2

The Monetary Policy Committee print more money (quantitative easing) in order to increase inflation (by lowering the price of money) and The Bank of England also lower interest rates to alter inflation

Question 3

Name three causes of inflation

Answer 3

Demand-pull inflation Cost-push inflation Increasing money supply

Question 4

Define demand-pull inflation

Answer 4

when aggregate demand outpaces aggregate supply e.g. by increasing consumer confidence thus increasing consumer spending,

Question 5

Define and explain cost-push inflation

Answer 5

inflation caused by an increase in prices of inputs e.g. increasing cost of raw materials like oil

Question 6

Explain how increasing the money supply causes inflation

Answer 6

Increase in money supply can cause inflation because if ceteris paribus, then the price of items will increase if the real output of the economy is constant as M x V = P x Y but if recession firms increase real output instead e.g. by quantitative easing

Question 7

Explain the effects of inflation on consumers

Answer 7

• Those on low and fixed incomes are hit hardest by inflation because the cost of necessities such as food and water becomes expensive. The purchasing power of money falls which affects those with high incomes the least (income inequality etc) - if nominal wages stay the same and the price levels increase then real wages will fall. - If consumers have loans, the value of the repayment will be lower because the amount owed does not increase with inflation so the real value of debt decreases.

Question 8

Explain the effects of inflation on firms

Answer 8

• Low interest rates means borrowing and investing is more attractive than saving profits. With high inflation, interest rates are likely to be higher, so the cost of investing will be higher and firms are less likely to invest - Workers might demand higher wages which could increase the costs of production for firms. - Shoe leather costs – opportunity cost of time and energy that people spend trying to counter-act the effects of inflation such as holding less cash or less trips to the bank - Menu costs – cost to a firm resulting from changing prices required when inflation exists, refers to the costs of changing nominal prices. - Firms may be less price competitive on a global scale if inflation is high as eu citizens don’t want to invest when prices are rising if other countries are lower - Unpredictable inflation will reduce business confidence causing less investment

Question 9

Explain the effects of inflation on the government

Answer 9

• the government will have to increase the value of the state pension and welfare payments as the cost of living increases - real burden of national debt decreases

Question 10

Explain the effects of inflation on workers

Answer 10

• if firms face higher costs there could be more redundancies when firms try and cut their costs

Question 11

Explain the problems associated with deflation

Answer 11

• discourage spending low consumer confidence causing economic stagnation and unemployment
• increase real debt burdens
• firms profits decrease so wages decrease or let workers go

However

• lower prices makes UK goods more competitive so exports increase improving trade balance
• improves distribution of income as hits wealthiest harder as hold more assets
• decreases cost of expenditure

Question 12

How does demand pull inflation occur

Answer 12

increasing consumer confidence thus increasing consumer spending, a depreciation in exchange rates causing imports to become more expensive whilst exports become cheaper so we import less export more increasing (x-m) causing AD to rise, lower interest rates so less saving more borrowing more consumer spending, a reduction in income tax so more income so more spending a rise in house prices so people wealthier so spend more

Question 13

How does cost push inflation occur

Answer 13

increasing component cost - i.e. due to rise in world commodity prices such as oil copper agriculture products rising labour costs due to wage pressure from low unemployment

Question 14

Quanity theory of money states that

Answer 14

MV=PY

Question 15

How might an increase in the money supply result in inflation

Answer 15

if V and Y are constant ceterus paribus firms cant produce more goods increase money supply through quantitative easing to increase prices i.e. inflation

Question 16

How might an increase in the money supply not cause inflation

Answer 16

If in recession then an increase in money supply would increase output as firms want to stimulate demand rather than increase prices

Question 17

Problem with increasing money supply

Answer 17

can lead to deflationary pressure when taking money out as decreasing money supply

Question 18

We can assume the velocity is constant because

Answer 18

wages and bills being paid monthly and goods and services bought after wages

Question 19

Why is low and stable inflation good and bad

Answer 19

Exports increase imports decrease decreasing deficit Higher real wages Lower nominal interest rates encouraging borrowing Falling prices discourages spending Can go out of control Increases unemployment Increases real burden of debt