Inflation test Flashcards
How inflation is calculated
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.
Internal causes of inflation
Large surge in property prices.
Higher wages/labour costs.
Boom in credit/money supply
Rise in business taxes, for example VAT
External causes of inflation
Increase in world oil/gas prices
Inflation in global commodity prices
Deprivation of the exchange rates
Higher inflation in other countries
Effects of inflation
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
Effects of inflation on the government
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.
Inflation
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.
Hyper inflation
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.
Deflation
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.
Disinflation
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%.
Inflation expectations
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.
Stagflation
Stagflation refers to an unfortunate and costly combination of stagnant (slow) economic growth, rising unemployment and high and rising inflation.
Consumer Price index
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.
Consumer Price index- weights
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
calculating inflation using a price index
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%
limitations of the uk consumer price index
-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.
challenges in measuring inflation (overview)
-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.
Consumer price inflation in the UK
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.
Main causes of inflation
Money & credit boom
Higher wage costs
Increased energy bills
falling exchange rates
higher indirect taxes- tax on goods and services
economic boom
Cost-push inflation
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.
Causes of cost push inflation
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.
demand- pull inflation
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.
Causes of demand pull inflation
-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
Milton Friedman
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.
Basics of Monetarism
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.
