MACRO - LS8 - Inflation Flashcards
Inflation definition
Persistent change in average price level of goods/services in an economy over a period of time
Two main ways of measuring inflation
Consumer price index (CPI)
Retail price index (RPI)
Survey given to measure inflation
Living costs and food survey - measures prices in different areas of the country and different shops
What is the difference between RPI & CPI
Retail price index tends to be higher then CPI
Why is there a difference between RPI & CPI
- 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
Redistribution effects
Inflation redistributes income away from certain groups and towards other groups
Some have an increase in PPP, some have a decrease
Groups who lose from inflation
- ppl who received fixed wages
- ppl who receive income/wages that increase less rapidly then inflation
- holders of cash
- savers
- lenders
Ppl who receive fixed wages
- 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
ppl who receive income/wages that increase less rapidly then inflation
- when income doesn’t keep up with price level, real income falls and they become worse off
Holders of cash
As price level increases, real value/PP of cash falls
Savers
- 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
Lenders
- 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
Groups who gain from inflation
- borrowers
- payers of fixed income/wages
- payers of income/wages that rise less rapidly then inflation
Borrowers
Pay back money that’s real value has fallen, makes you better off at the end of the loan period
Payers of fixed incomes/wages
As long as income is fixed, layers benefit as real value of payments fall due to inflation
Payers of income that increase less rapidly then inflation rate
- payers benefit as falling real value of payment
Uncertainty
- 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
Menu costs
- 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
Money illusion
- 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
International (export) competitiveness
- 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
Appropriate inflation rate
- 2%
- 0% to close to deflation
Demand-pull inflation
•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
Causes of demand-pull inflation
- 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
Growth of money supply
- 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
Cost-push Inflation
- occurs due to rising costs - causes a decrease in supply
Causes of Cost-push Inflation
- 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
