MACRO - LS8 - Inflation

Question 1

Inflation definition

Answer 1

Persistent change in average price level of goods/services in an economy over a period of time

Question 2

Two main ways of measuring inflation

Answer 2

Consumer price index (CPI)
Retail price index (RPI)

Question 3

Survey given to measure inflation

Answer 3

Living costs and food survey - measures prices in different areas of the country and different shops

Question 4

What is the difference between RPI & CPI

Answer 4

Retail price index tends to be higher then CPI

Question 5

Why is there a difference between RPI & CPI

Answer 5

• RPI uses Carli Index (arithmetic mean) vs CPI using geometric mean - the difference in methods caused the RPI to be overstated, and the CPI is more accurate
• CPI excludes items relating to housing including mortgage interest rate payments and council taxes, included in RPI - these items tends to rise in price faster then other items
• RPI & CPI cover different sample populations - RPI excludes top 4% of income earners and low income pensioners on the basis they aren’t typical households

Question 6

Redistribution effects

Answer 6

Inflation redistributes income away from certain groups and towards other groups
Some have an increase in PPP, some have a decrease

Question 7

Groups who lose from inflation

Answer 7

• ppl who received fixed wages
• ppl who receive income/wages that increase less rapidly then inflation
• holders of cash
• savers
• lenders

Question 8

Ppl who receive fixed wages

Answer 8

• when income is constant as general price level increases they become worse off - occurs when:
• wage contracts fixing wages over time period
• fixed pensions
• fixed rental income
• fixed welfare payments

Question 9

ppl who receive income/wages that increase less rapidly then inflation

Answer 9

• when income doesn’t keep up with price level, real income falls and they become worse off

Question 10

Holders of cash

Answer 10

As price level increases, real value/PP of cash falls

Question 11

Savers

Answer 11

• in order to maintain real value, savers must receive the rest that’s equal to rate of inflation
• if not real value of savings fall

Question 12

Lenders

Answer 12

• people who lend money may be worse off due to inflation
• if you lend money then there is an increase in price level, then money you get back will have fallen in real value

Question 13

Groups who gain from inflation

Answer 13

• borrowers
• payers of fixed income/wages
• payers of income/wages that rise less rapidly then inflation

Question 14

Borrowers

Answer 14

Pay back money that’s real value has fallen, makes you better off at the end of the loan period

Question 15

Payers of fixed incomes/wages

Answer 15

As long as income is fixed, layers benefit as real value of payments fall due to inflation

Question 16

Payers of income that increase less rapidly then inflation rate

Answer 16

• payers benefit as falling real value of payment

Question 17

Uncertainty

Answer 17

• can’t accurately predict inflation in future and therefore change in PP - causes uncertainty among economic decision-makers
• firms become more cautious as they can’t accurately forecast cost/revenue - leads to less investment and therefore economic growth

Question 18

Menu costs

Answer 18

• costs to firms when have to print new ‘menus’ - e.g. pricing due to change in price
• higher inflation rate more often prices change and therefore menu costs

Question 19

Money illusion

Answer 19

• some people feel better when nominal wage increases despite price level often increasing - can actually be the same or worse off
• if money illusion is widespread it can lead to consumers making wrong spending decisions

Question 20

International (export) competitiveness

Answer 20

• as inflation increases in a country compared to countries it trades with exports are more expensive to foreign buyers and imports are cheaper to domestic buyers
• exports fall and imports increase - can affect balance of payments

Question 21

Appropriate inflation rate

Answer 21

• 2%
• 0% to close to deflation

Question 22

Demand-pull inflation

Answer 22

•Demand-pull inflation is caused by excessive demand in the economy for goods and services - therefore average price level rises.
• There is too much money chasing too few goods and services
• The best way to think about this is using the AD formula: C + | + G + (X-M)
• Remember, consumption is the largest component of AD, although any stimulant to AD will create some demand-pull inflationary pressure if supply remains unchanged
- happens when there is no increase in AS

Question 23

Causes of demand-pull inflation

Answer 23

• Reduced taxation - Increases disposable income
• Lower interest rates - Makes borrowing more attractive and saving less rewarding
• A general rise in consumer spending - Perhaps from higher incomes and consumer confidence
• Fast growth in other countries - May increase demand for UK exports
• General rise in confidence / expectations of future growth - May feed through to higher consumer spending and investment
• increase in government spending
• also influenced by growth of money supply

Question 24

Growth of money supply

Answer 24

• if banks increase lending to customers money supply will growth so they will be more likely to spend money - causing increase AD and demand-pull inflation

Question 25

Cost-push Inflation

Answer 25

• occurs due to rising costs - causes a decrease in supply

Question 26

Causes of Cost-push Inflation

Answer 26

• Wage increases - It is likely that if prices are rising, workers will demand higher wages in order to maintain their ‘real’ incomes - If these higher wage costs are reflected in higher prices, then workers will continue to demand higher wages, leading to a wage-price spiral
• Higher raw material costs - As primary raw materials become more scarce and in even greater demand, raw materials and associated components may rise in price
• Higher taxes - The government may impose higher taxes on firms; for example, corporation tax, national insurance or taxes on waste disposal
• Higher import prices - A weaker exchange rate or rising prices abroad mean that imported components feed through to higher costs of production
• firms will protect profit margins - competition in market means it may be harder to pass on costs
• can also try to improve profit margins - more inelastic demand is, less the increase in price will effect demand for products