Macro 7 - Inflation Flashcards
How is the Consumer price index (CPI) used to calculate inflation?
- The first survey consists of 7000 households which are sampled using self-reported diaries
- This is to find out what goods and services people are currently buying
- The proportion of income spent on each item is used to work out a weighting
- This annual survey is used to determine the contents of a virtual basked of goods that households spend their money on
- The second survey relates to prices. Data is collected once a month about changes in prices of the 700 most commonly used goods
- The price changes are multiplied by the weights to give a price index
- Inflation is then the percentage change in the index from one year to the next
What are some of the limitations of the consumer price index (CPI) ?
- It excludes some housing costs such as mortgage payments which often form a large part of a household’s spending
- There are sampling problems as only 57% of households respond to the survey and if they do respond they may not give accurate information about their spending
- The CPI is only an average figure for price levels. Many people will experience different inflation rates that depend on their own personal pattern of expenditure
- The CPI does not take quality changes into account
- The 700 items in the basket are only updated once a year but tastes and fashion may change more quickly than this
What is the consumer price index?
The consumer price index is a measure of the average price levels of goods and services in the UK
How is the Retail price index (RPI) used to measure inflation?
- Two surveys are carried out calculate the RPI
- The first survey is a survey of around 6000 households called the Living costs and food survey. This is used to found out what people spend their money on and the proportion of people’s income spent on these items. This is used to work out the relative weighting of each item
- The second survey is based on prices, it measures the changes in price of around 700 of the most commonly used goods and services
- The items are chosen based on the Living costs and food survey. What is in the basket changes over time to reflect changes in technology, trends and tastes. This ensures that the basket always reflects what the average households might spend its money on
- The price changes in the second survey are multiplied by the weightings from the first survey. These are then converted to an index number. So inflation is just the percentage change to the index numbers over time.
What are the 3 different causes of inflation?
- Demand pull inflation
- Money supply
- Cost push inflation
Define the term demand pull inflation
An increase in the general level of prices caused by increases in consumer spending, investment, government spending or net exports (an increase in aggregate demand)
What is money supply as a cause of inflation?
Money supply is the amount of spending power in an economy. It includes cash and bank deposits. Monetarists believe than an increase in the money supply has a direct relationship with inflation
Define the term cost push inflation
An increase in the general price level caused by increased production costs such as rises in wages or a fall in the exchange rate making imports more expensive
What are the effects of inflation on consumers?
- The purchasing power of incomes fall as prices rise causing people’s standard of living to fall
- The real value of savings fall as prices rise
- People may buy now rather than delaying which may cause demand pull inflation causing even more inflation
- Those with high levels of debt benefit as the real value of debt falls
What are the effects of inflation on firms?
- There is a loss of international competitiveness as exports become relatively expensive and imports appear cheaper
- An increase in menu costs as firms constantly have to change price lists creating an opportunity cost in terms of time and money
- Increased uncertainty and less investment
What are the effects of inflation on the government?
- It may be difficult to ensure that public sector wage rises and pension increases are in line with inflation
- Inflation reduces the real value of government debt
What factors does the impact of inflation depend on?
- The inflation rate
- Anticipated inflation
- Inflation abroad
- The cause of inflation
Define the term deflation
Deflation is a decrease in the general level of prices
What are the general effects of deflation?
- It can be a sign of low aggregate demand which can reduce confidence
- Deflation will encourage people to delay their spending and save their money as consumers will expect products to be cheaper later. This is bad for the economy as low spending leads to low AD which causes more deflation
- The real value of debt rises
- Firms cannot charge as much for goods and services which reduces the incentive to produce increasing unemployment
