LS8 Inflation Flashcards
Define inflation
Inflation is a sustained increase in the cost of living or the general price level (GPL) leading to a fall in the real purchasing power of money.
Define inflation rate
What is the inflation target?
How is it measured?
- The rate of inflation is measured by the annual percentage change in consumer prices. It is the change in average prices in an economy over a given time period.
- The UK government has set an inflation target of 2% using the consumer prices index (CPI)
- a basket of goods is measured with weighted items
Describe the CPI
How it’s done
- The Consumer Prices Index is the main measure of inflation used in the UK and the EU.
- A base year for prices is selected, and a family expenditure survey is carried out – the survey covers many thousands of UK households. The survey tracks what people are buying from month to month.
- A representative basket of over 700 goods and services is used, and weights are attached to each item – these are based on these items’ importance in people’s expenditure.
- Weights are then multiplied by price changes for each item in the index
- The weighted price changes are then totalled to calculate the inflation rate
Compare the RPI and CPI inflation rates
- RPI tends to be above the CPI
- This is because the RPI uses the Carli index (arithmetic mean) and the CPI uses a geometric mean.
- The office for National statistics stated that the use of the Carli index meant inflation was overstated, and the CPI was more accurate
- An additional measure of the RPI is called the RPI J, which would use the same data and weights, but would be calculated using the Jevons index (geometric, mean)
- RPI and CPI differ because CPI excludes housing related items, e.g. mortgage and council tax, but since housing costs have risen faster than other items. CPI shows lower inflation than RPI
- RPI also covers a different sample of the population and excludes the top 4% of income earners and low income pensioners. Where is CPI covers all household and all incomes
What does inflation do to income?
Inflation redistribute income away from certain groups and towards others. This arises in situations where certain groups lose purchasing power and become worse off while others gain purchasing power and become better off.
State and explain the group who lose from inflation
People who receive fixed incomes or wages
- When individuals receive an income that is fixed as the general price level increases, they become worse off
- This is because the real value of their income decreases as inflation increases
- For example: workers have wage contracts fixing their wages over a period of time/pensioners received fixed pensions/landlords receive fixed rental income/individuals receive fixed welfare payments
People who receive income or wages that increase less rapidly than the rate of inflation
- When individuals incomes do not keep up with the rising price level of all in the real income results, and they become worse off, these groups may include all of those above
Holders of cash
- as the price level increases the real value of any cash held falls
Savers
- People who save money can become worse off because in order to maintain the real value of their savings, the rate of interest of the bank must be equal to the rate of inflation
- If the interest rate given by the bank is lower than the rate of inflation, the value of the money erodes
Lenders/creditors
- People who lend money may be worse off, because if they do not charge any interest, the real value of the money that they are repaid is less than the initial value that they lent out, so they make a loss
-This only happens when the interest rate given by the lender is lower than the rate of inflation
State and explain the groups who gain from inflation
Borrowers/ debtors:
- say you borrows £100, if your friend charges interest, you will benefit as long as the rate of interest is lower than the rate of inflation. Borrowing at a lower interest rate than the rate of inflation makes the borrower better off at the end of the loan period because you pay back less value than you initially took.
Payers of fixed income, or wages
- As long as nominal wages/pensions/rent/welfare payments are fixed while there is inflation, the payers benefit as the real value of the payment falls due to inflation
Payers of income, or wages that increase less rapidly than the rate of inflation
- The pay is benefit because the real value of the payments fall
What are some other consequences of inflation?
Uncertainty
- Being unable to predict what information will be in the future means people cannot predict changes in purchasing power
- This means economic decision makers are uncertain and firms in particular become more cautious about making future plans, because they are unable to make accurate forecasts of costs and revenues because these depend on the future prices of inputs and products
- This uncertainty can lead them to make fewer investments, and this may lead to low economic growth.
Menu costs
- This is a cost incurred by firms when they have to print new menus/catalogue/advertisements/price labels due to changes in prices
- the higher the rate of inflation, the more often prices change, therefore the higher the menu costs
Money illusion
- This is the idea that some people feel better off when their nominal income increases even though the price level may increase at the same rate and possibly even faster. When this occurs people feel they are better off even though their real income has not changed and may have decreased
- If this is widespread, it has a negative consequences because it will lead consumers to make wrong spending decisions
International (export) competitiveness
- When the price level in a country increases more rapidly than the price level in other countries, its exports become more expensive to foreign buyers and imports become cheaper to domestic buyers
- Therefore international competitiveness is reduced (fall in exports and increase in imports) which would create difficulties for the countries trade balance
What is an appropriate rate of inflation?
- Most governments prefer low and stable rate of inflation. Not zero. This is because a zero rate of inflation is too close to deflation, which could cause serious problems for an economy.
- There is no ideal particular rate of inflation, but most government would like to see inflation in the range of 2-3%/year
- less than 2% is too close to deflation, over 4% is too high
What are the two reasons which inflation can be caused by?
It can be caused by two main factors: too much demand in the economy/rising costs
demand-pull inflation
Cost-push inflation
Explain demand-pull inflation
How do excessive rises in AD come about?
- If aggregate demand rises, and there is no increase in aggregate supply then demand-pull inflation is likely to occur
- Demand-pull inflation is caused by excess demand in the economy. Which causes the price level/average level of price in economy to rise.
Excessive increases in AD in the UK, can come about because of:
- An excessive rise in consumer spending: this may be because of low interest rates or high consumer confidence caused by a rise in house prices
- Firms substantially increasing their spending on investment: perhaps to respond to large increases in demand (invest in extra capacity to satisfy it)
- Government increasing its spending substantially or cutting taxes
- World demand for UK exports rising because of a boom in the world economy
- growth of the money supply. Banking can influence the amount of borrowing and lending in the economy. If banks increase their lending then consumers are likely to spend the money which would result in increased aggregate demand which would cause inflation example, would be Germany 1923
Explain cost-push inflation
Changes in the supply side of the economy can cause cost push inflation because of rising costs. There are four major sources of increased costs:
- wages and salaries are the most important cause of increases in the cost of production (when they increase)
- Imports can cause a rise in price because they boom in the world economy can push up commodity prices and will push out the price of finished goods leading to higher import prices for the UK
- To raise profit firms may raise the price to improve profit margins and the more price inelastic the demand for the good is the smaller the fall in demand will be
- Governments can raise indirect tax rates or reduce subsidies, which would increase prices
Then:
- firms will pass on the increases in their costs to consumers. Although competition in the market may mean it is difficult to pass on these price, rises and maintain sales at the same time, but if costs are rising overtime firms will have to which would lead to inflation.
It is important to note in a stable but growing economy with no demand-side or supply-side shocks inflation is likely to be caused by a mix of the two factors .
Define deflation
This is a sustained decrease in the general price level. The inflation rate dips below zero.
Define disinflation
This is when the rate of inflation declines but still remains positive. Prices are still rising but at a slower rate than before
What are some limitations of CPI in measuring inflation?
- Substitution Bias: CPI assumes constant consumption patterns, whereas consumers often adjust their purchases in response to changing prices. This can lead to an overestimation of inflation.
- Quality Changes: CPI may not adequately account for quality improvements in goods and services over time. This can result in an overestimation of price increases.
