Inflation test

Question 1

How inflation is calculated

Answer 1

CPI is a price index that measures the price changes in a basket of goods that are consumer faces. RPI is a price index that uses the same principles of CPI, but ultimately use a different basket of goods/services to measure inflation, and the average is calculated in a different way.

Question 2

Internal causes of inflation

Answer 2

Large surge in property prices.
Higher wages/labour costs.
Boom in credit/money supply
Rise in business taxes, for example VAT

Question 3

External causes of inflation

Answer 3

Increase in world oil/gas prices
Inflation in global commodity prices
Deprivation of the exchange rates
Higher inflation in other countries

Question 4

Effects of inflation

Answer 4

Causes problems for consumers as they find their money doesn’t go as far as it used to.
Effective business is because it can lead to uncertainty and instability, E.G.businesses may have a hard time planning for the future and making long-term investment when inflation is high.
When inflation, high central bank usually raises interest rates in attempt to curve inflation
Cost of borrowing – inflation leads to higher interest rates for businesses and consumers with debts
Reduced demand for country exports

Question 5

Effects of inflation on the government

Answer 5

Pressure on government to raise value of state welfare benefits, including the state pension or out of work benefits to help control poverty.
High inflation can cause real GDP growth to slow – can lead to lower tax revenues and the government, then having to borrow more money
Can lead to increase in market interest rates, making borrowing more expensive when they issue new bonds
High relative inflation can lead to worsening of international competitiveness causing fall in exports which can threaten jobs and GDP growth.

Question 6

Inflation

Answer 6

Inflation is a sustained rise in an economy’s general price level. This means that, on average, the prices of goods and services are going up over time. It’s a normal part of a healthy economy, but if inflation gets too high it can cause serious problems. When inflation happens peoples money is worth less in real terms, which means they must spend more to get the same goods and services. In extreme cases it can lead to hyper inflation.

Question 7

Hyper inflation

Answer 7

Hyper inflation is a phase of extremely rapid inflation nearly always the result of mass money printing by the government with money as an asset ending up as worthless. It is also associated with economies where there has been a collapse in real output/ supply.

Question 8

Deflation

Answer 8

Deflation is a sustained period when the general price level for goods and services is falling. This means that a weighted basket of goods and services is becoming less expensive over time. The annual rate of inflation is negative.

Question 9

Disinflation

Answer 9

Disinflation is a fall in the rate of inflation but not sufficient to bring about price deflation. During a period of disinflation, consumer prices are still rising but at a slower rate, for example a drop in the annual inflation rate from 7% to 2%.

Question 10

Inflation expectations

Answer 10

Inflation expectations describes what people and businesses expect to happen to consumer prices in the future (usually one year ahead). Once a high rate of inflation becomes established it can be difficult to remove. If people expect higher prices, this can then feed through to higher wage claims and rising costs. This is known as a wage-price spiral.

Question 11

Stagflation

Answer 11

Stagflation refers to an unfortunate and costly combination of stagnant (slow) economic growth, rising unemployment and high and rising inflation.

Question 12

Consumer Price index

Answer 12

A Consumer Price Index (CPI) is a measure that tracks changes in the average price level of a basket of goods and services purchased by a typical household over time.
It is a widely used economic indicator for assessing inflation and cost of living adjustments.
CPI is calculated by comparing the current prices of the items in the basket to the prices of the same items in a base year or period.
The percentage change in this comparison reflects the inflation or deflation rate.

Question 13

Consumer Price index- weights

Answer 13

The consumer price index is a weighted price index
These weights are based on the spending patterns of households on a wide range of goods and services
In the UK, housing and household services account for 30% of the inflation calculation
Food and non-alcoholic drink is now less than 10% of the index
The weights are altered periodically to take account of changing spending patterns
CPIH is the CPI including housing

Question 14

calculating inflation using a price index

Answer 14

Calculating the consumer price index for 2023
1.Select prices in 2022 as the base year for the calculation, the index = 100
2.Multiply 2023 price index data for each category by their individual weighting
3.Sum of price x weights = 102,000
4.Then divide this number by the sum of the weights (1,000)
5.This gives a price index for 2023 of 102
6.The rate of inflation in 2023 in this example was therefore 2%

Question 15

limitations of the uk consumer price index

Answer 15

-The CPI basket is not fully representative of all consumers - it will be inaccurate for non-typical households, for example - 10% of CPI index covers motoring costs – inapplicable for non-car owners. Single people will spend differently from those with children
-Errors / inaccuracies in data such as sampling errors from surveys.
-Many of the services in the digital economy do not have a price such as Google searches, WhatsApp and Instagram feeds
-Changing quality of goods and services: a rise in the quality of products may not be easily reflected in the prices we pay
-Time lags: The CPI is slow to respond to new products in markets – the CPI basket is changed each year but only by a little.

Question 16

challenges in measuring inflation (overview)

Answer 16

-Basket of goods and services: Consumer preferences evolve over time, and the basket may not always accurately reflect what people are buying.
-Substitution bias: Consumers tend to adjust their spending patterns in response to price changes. When the price of a particular item rises significantly, people may switch to cheaper alternatives.
-Quality adjustments: The CPI must make quality adjustments to account for quality changes, which can be subjective and challenging to quantify accurately.
-Geographic variation: The CPI is typically a national measure and may not capture regional variations in prices effectively.
-Subgroups and demographics: CPI represents an average consumer, and the inflation experience can vary among groups, such as age, incomes, or urban vs. rural populations.

Question 17

Consumer price inflation in the UK

Answer 17

The Uks official inflation target is 2%. This is the target that the Bank of England, the UK’s central bank, is trying to achieve. The bank of England uses various tools to try to keep inflation at this level, including setting interest rates. When inflation is above the target, the Bank of England typically raises interest rates to try to slow down the economy and bring inflation back down.

Question 18

Main causes of inflation

Answer 18

Money & credit boom
Higher wage costs
Increased energy bills
falling exchange rates
higher indirect taxes- tax on goods and services
economic boom

Question 19

Cost-push inflation

Answer 19

Cost-push inflation occurs when businesses respond to rising unit costs by increasing prices to protect their profit margins. Cost push inflation can come about from both domestic and external sources including a fall in the external value of the exchange rate which then leads to a rise in prices of imported products.

Question 20

Causes of cost push inflation

Answer 20

1.Rising labour costs perhaps due to an increased minimum wage
2.Higher global prices for components and raw materials including imported energy (oil and gas) and foodstuffs
3.A depreciation in the external value of the exchange rate which then causes a rise in import prices – many imports are priced in US $s
4.An increase in indirect taxes such as higher VAT or environmental taxes such as a carbon tax
Key point: Inflation from cost-push factors can be difficult to control, since the central bank has little control over the factors that cause it.

Question 21

demand- pull inflation

Answer 21

Demand-pull inflation is a phase of accelerating inflation which arises from a rapid growth in aggregate demand. It occurs when economic growth is too fast. Businesses can take advantage of high demand by raising their prices to widen (increase) profit margins. Typically, demand-pull inflation is associated with an economic boom.

Question 22

Causes of demand pull inflation

Answer 22

-Demand-pull inflation happens when the economy is growing too quickly, and aggregate demand for goods and services outstrips supply.
-When this happens, prices for everything start to rise, because consumers are willing to pay more to get the things they want.
-This can be caused by several things, including economic growth, low interest rates, and an increase in the money supply.
-If the government engages in excessive fiscal stimulus, like cutting taxes or increasing spending, it can boost demand and lead to inflation.
-This kind of inflation is often seen as a sign that the economy is “overheating” and that corrective measures need to be taken

note: fiscal = taxes + government spending. e.g. national insurance or NHS spending

Question 23

Milton Friedman

Answer 23

Milton Friedman was one of the most influential economists of the 20th century, and he was a leading advocate of monetarism.
He was an American economist and statistician who taught at the University of Chicago for many years.
In 1976, he won the Nobel Prize in Economics for his work on consumption analysis, monetary history, and the relationships between inflation and unemployment.
He’s well known for his strong support of free-market policies and opposition to government intervention in the economy. His ideas were hugely influential during the 1980s and 90s.

Question 24

Basics of Monetarism

Answer 24

Monetarism suggests that the amount of money in an economy plays a crucial role in determining the overall price level, or inflation.
If the central bank increases the money supply too rapidly, it can lead to inflation because there is “too much money chasing too few goods.”
Monetarists are often critical of using fiscal policy (government spending and taxation) to manage the economy. They argue that fiscal policies can be unpredictable and lead to economic instability.
Monetarists also believe in the concept of long-run neutrality of money. This means that in the long term, changes in the money supply do not affect real variables like employment and output but primarily impact nominal variables like prices.

Question 25

causes of the surge in uk inflation in 2022-23

Answer 25

-Pandemic-related supply shortages: As the world economy recovered from the pandemic, demand for these supplies and materials increased, but the supply couldn’t keep up. This led to higher prices for raw materials and products, which pushed up inflation.
-Conflict in Ukraine: The conflict has caused a spike in energy prices, as Russia is a major exporter of natural gas and other fuels. Higher energy prices have pushed up the cost of production for many businesses.
-Labour shortages: These have been a big problem in the UK, especially in sectors, like healthcare and logistics. A lack of workers has made it difficult for businesses to operate, and it’s pushed up wages for those workers who are available

Question 26

Greedflation

Answer 26

Greedflation is also known as price gouging
Price gouging refers to the practice of charging excessive or unreasonable prices for goods or services in response to a situation of increased demand or limited supply, such as during a natural disaster, pandemic, or other emergency.
In such situations, demand for certain goods or services may increase dramatically, and the supply may be constrained, leading to scarcity and higher prices.
Price gouging occurs when sellers take advantage of this situation by charging prices that are much higher than what would be considered reasonable under normal market conditions.

Question 27

Growth of money supply as inflation cause

Answer 27

The growth of the money supply can be a cause of inflation when it outpaces the growth of real economic output (goods
and services produced).
This concept is often described by the Quantity Theory of Money, which states that the price level in an economy is
directly related to the money supply and the velocity of money (how quickly money circulates in the economy) relative to the quantity of goods and services produced.

Question 28

inflationary effects of rising money supply

Answer 28

As the money supply grows, individuals and businesses have more to spend. If the supply of goods and services in the economy does not increase at the same rate (or if it decreases), the demand for these goods and services can exceed their supply.
When demand exceeds supply, sellers can increase their prices to capture more of the available money.
Expectations of future inflation can further exacerbate the problem. If people anticipate that prices will continue to rise, they may make purchases sooner rather than later, which can fuel additional demand and price increases.
Rising prices can lead to demands for higher wages as workers seek to maintain their real purchasing power.

Question 29

Shrinkflation

Answer 29

refers to practise of companies reducing the size or quantity of a product while keeping the price the same or even raising it. This allows companies to keep prices stable or even increase them, without consumers noticing as much. It’s a form of hidden inflation that can be difficult to detect. Companies may shrink the size of products, reduce amount of product in a container or even reduce the quality of the product

Question 30

importance of the relative inflation rate

Answer 30

-A country’s relative inflation rate matters because it can affect its competitiveness in international trade.
-If one country has high inflation, while another country has low inflation, that can lead to an imbalance in trade.
-The country with high inflation will see its exports decline, while the country with low inflation will see its exports increase.
-This can lead to imbalances in the balance of trade, and it can also cause problems for the country with high inflation, since it will become less competitive in the global marketplace.
-In extreme cases, this can lead to problems like capital flight and debt crises

Question 31

high inflation and the risk of capital flight

Answer 31

-When a country experiences high inflation, investors may start to worry about the stability of the economy.
-They may fear that the high inflation will lead to a decline in the value of the country’s currency.
-To protect their assets, these investors may decide to move their money out of the country, in a process known as “capital flight”.
-They might do this by selling their assets in the country, like stocks or real estate, and then moving the proceeds to a different country, like one with a more stable currency.

Question 32

consequences of a high rate of inflation

Answer 32

-The main reason economists view inflation as damaging is because it erodes the value of money.
-This can cause problems for consumers, who find that their money doesn’t go as far as it used to.
-It also affects businesses, because it can lead to uncertainty and instability. For example, businesses may have a harder time planning for the future and making long-term investments when inflation is high.
-When inflation is high, the central bank will often raise interest rates in an attempt to curb inflation

Question 33

high inflation & yields on government bonds

Answer 33

-When a government issues new bonds, it has to offer a certain interest rate, known as the “yield”, to attract investors.
-If inflation is high, the government will have to offer a higher yield on its bonds to entice investors to lend it money.
-This is because investors will want to be compensated for the risk of inflation eroding the value of their investment. In other words, they’ll want to earn enough interest to offset the effects of inflation.
-High inflation leads to higher interest rates on government bonds.
-When governments must pay higher interest rates on their bonds, they ultimately increase taxes to pay off the interest

Question 34

economic costs of high inflation

Answer 34

-Inequality: Inflation has a regressive effect on lower-income families in developed & developing countries – most of their wealth is held in cash
-Falling real incomes – if wage rises lag price increases each year
-Negative real interest rates: If the interest rate on savings is lower than inflation
-Cost of borrowing: High inflation may also lead to higher interest rates for businesses and consumers with debts (perhaps via rising mortgage rates)
-International competitiveness: A high relative rate of inflation can reduce competitiveness which will lower demand for the country’s exports
-Business uncertainty: High and volatile inflation is not good for confidence because businesses cannot be sure of what costs will be – this might hold back investment

Question 35

Winners and losers of Inflation

Answer 35

Winners:
Workers with strong wage bargaining power (perhaps those workers who belong to trade unions)
Debtors if real interest rates on loans become negative (when the nominal interest rate is less than inflation)
Producers if their prices continue to rise faster than costs (leading to higher profits)

Losers:
Retired people relying on fixed incomes/ pensions
Lenders if real interest rates on loans are negative
Savers if real returns on their savings deposits are negative
Workers in low paid jobs with little or no bargaining power- perhaps those with no union representation

Question 36

Economic costs from deflation

Answer 36

1/ Falling wages – businesses need to cut their costs to maintain profits – they may decide to reduce jobs
2/ Real value of debt goes up – makes it harder to repay that debt (including mortgages & government bonds)
3/ Consumers might hold back their spending – expecting price falls – lower C leads to fall in AD
4/ Investment may slump (fall in C) & diversion overseas
5/ Real interest rate on debt / savings will rise
Example: Nominal interest on loan = 2%
Inflation = -2%, real interest rate = 2% - (-) 2% = +4%

Question 37

Economic / business opportunities from a period of deflation

Answer 37

1/ Fall in general prices - might increase real incomes of poorer families (perhaps due to strong currency)
2/ Rise in demand for “value products” – business must offer value for money
3/ Asset prices falling can improve housing affordability – important for first time buyers

Question 38

Asset price deflation

Answer 38

When the valuations of assets such as bonds, housing and equities fall over a sustained period. This often happens at the end of a financial bubble.

Question 39

Economic impact of a period of deflation

Answer 39

-Real interest rates rise
-Real level of debt rises
-Pressure for lower wages
-Declining business profits
-Rise in cyclical unemployment
-Improved price competitiveness

Question 40

Consequences of price deflation- overview

Answer 40

-Holding back on spending: Consumers may postpone demand if they expect prices to fall
-Debts increase: Real value of debt rises with deflation - can be a drag on consumer confidence
-Real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.
-Lower profit margins: Lower prices can mean reduced revenues & profits for businesses - this can then lead to higher unemployment as firms seek to reduce costs by shedding labour.
-Confidence and saving: Falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence
-Income distribution: Deflation leads to a redistribution of income from debtors to creditors – but debtors may default on loans
-Deflation can make exporters more competitive eventually – but this often comes at a cost such as. higher unemployment and weaker economic growth in the short term

Question 41

What macroeconomic policies might be used to tackle / prevent deflation?

Answer 41

1. Low interest rates and quantitative easing
   -In some countries, policy interest rates have become negative (Switzerland)
   -Expanding the supply of credit in banking system
   -QE used by many central banks including BoE and European Central Bank
2. Fiscal stimulus measures
   -Higher government spending (capital infrastructure projects)
   -A rise in government borrowing to inject demand into the circular flow
   -Lower direct taxes to increase disposable income and spending
3. Other measures to stimulate aggregate demand
   -Attempts to lower the value of the exchange rate (perhaps via central bank intervention to sell their own currency in the FOREX market)
   -Higher taxes on savings to encourage consumption of goods and services