LS8 - Inflation Flashcards
How is inflation measured
Prices of a basket of goods and services is recorded on a regular basis.
Living Costs and Food Survey used to record household expenditure on g/s
Average prices of selected goods calculated, converted to index num form
G/S are weighted in terms of importance - food given more weightage than tobacco - larger proportion of income spent on food
RPI VS CPI
RPI - arithmetic mean; includes housing costs, mortgage payments, Council Tax; excludes top 4% of earners and low income pensioners
CPI - geometric mean; excludes housing costs; includes all households and all incomes
RPI always greater values than CPI
Redistribution effects
Inflation redistributes money from certain groups in the economy to other groups.
Occurs when certain groups become worse off and lose purchasing power, while others become better off and gain purchasing power.
Groups who lose from inflation
People who receive fixed income - purchasing power of income falls; if wages increase at a rate lower than the rate of inflation - fall in real income
Holders of cash - real value and purchasing power of cash falls as price level increases
Savers - if inflation rate is higher than rate of interest, savers will lose money as real value of savings fall
Lenders - when borrowed money is returned, nominal value is the same, but after inflation, real value of the money has fallen, losing purchasing power
Groups who gain from inflation
Borrowers - borrowing at a lower interest rate than inflation means that the lender receives money with lower real value, so borrower is better off
Payers of fixed incomes - real value that you have to pay others decreases, so you would be better off
Demand - pull inflation
If AD increases, without an increase in AS, demand pull inflation occurs, as price of goods increase, caused by excess demand.
Causes of demand-pull inflation:
* Consumer spending may increase rapidly - interest rates could be low, so more spending on credit cards, or consumer confidence is increasing
* Firms may increase spending on investment - responding to large increases in demand by increasing working capacity
* Govt may be increasing spending, or cutting taxes
* World demand for UK exports might increase
* Growth of money supply - more lending –> more spending –> increase in AD –> inflation
Cost-pull inflation
Cost-push inflation occurs due to rising costs
* Increase in wages - increase in costs of production - inflation
* Imports - world economy booms, prices of goods internationally increases, imports in the UK get more expensive
* Firms looking to maximise profits will increase their prices - inflation
* Govts may increase taxes and reduce subsidies increasing the costs of production
Disadvantages of deflation
Discourages Consumption- when prices are falling, this encourages people to delay purchases of products because they will likely be cheaper in the future. This means you can increase the real value of your money by leaving it in a bank, as the purchasing power of your money increases when the price level falls. This increase in saving can lead to reduced consumption which can lead to lower investment and thus lower economic growth.
Increases the Real value of debt- Deflation increases the real value of money and thus the real value of debt as well. Deflation makes it more difficult for borrowers to pay off their debts, meaning that consumers and firms will have to spend a bigger percentage of their disposable income on meeting debt repayments. This can reduce both consumption and investment and thus growth too.
Costs of inflation
RUC
R ( Fall in REAL interest rates)- higher inflation causes the real interest rate to fall and so as a result borrowers will gain and lenders will lose. This may mean banks will be reluctant to lend money or may mean that they will raise their interest rates making it difficult for firms to borrow, resulting in lower investment and thus lower economic growth
U ( UNCERTAINTY)- Inflation can create uncertainty about future. If firms are uncertain about what their costs will be and what prices they will receive from selling their products they may be reluctant to invest. Inflation also makes it difficult for people to decide how much to save and where to place their savings.
C ( Loss of International competitiveness)- if a country’s inflation is above that of its main competitors, then the products that the country exports are rising in price faster than the price of the products they import. This is likely to result in a decrease in exports and rise in imports.
Why is inflation actually bad
As it has a number of adverse effects. For instance rising prices mean that the value of what savings can buy falls. If a person had £50 in savings and the price of a t shirt went up from £10 to £25 they would be worse off as their savings can only buy 2 compared to 5 before.
Another problem is that it disrupts knowledge of prices in a market.
Effects of inflation
Firms:
Fall in exports- if UK rate of inflation is higher than its main trading partners, the Uks international competitiveness ( degree to which a countrys goods and services can be sold on international markets)) will fall. Exports become expensive and imports seem cheap. Worsens balance of trade
Uncertainty- high inflation makes it difficult for firms to set budges which results in a fall in investment.
Lower profits- cost- push inflation causes decreaese in profits which results in lower investment. However, some inflation may result in increased revenue. Which means profits increases if there is demand pull inflation which encourages them to invest.
Government:
Fall in real value of national debt- inflation reduces value of debt owed by the government so it becomes less of a burden
Increased inequality- inflation makes it more difficult for a government to reduce income inequality because those on fixed incomes will see a fall in the real value of their incomes
Worsens balance of trade- exports fall, imports increase.
Workers:
Unemployment: a low inflation may imply low demand in economy and high rate of unemployment
Wages decrease for those on fixed incomes.
