Macro Unit 3- Inflation

Question 1

What is inflation?

Answer 1

Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money.

Government inflation target= 2%

Question 2

What is purchasing power?

Answer 2

Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing power is important because, all else being equal, inflation decreases the amount of goods or services you would be able to purchase.

Question 3

What is disinflation?

Answer 3

Disinflation is when there is a lower inflation rate meaning prices rise more slowly

Question 4

What is deflation?

Answer 4

Deflation is the reduction of the general level of prices in an economy.

Question 5

What are the 2 methods of measuring inflation in the U.K.?

Answer 5

1. Consumer Price Index (CPI)

2. Retail Price Index (RPI)

Question 6

What is RPI?

Answer 6

RPI measures the annual percentage change in consumer prices of goods and services, also known as the basket of goods, but also takes into account mortgage interest payments, meaning general interest rates affect RPI.

Question 7

What is CPI?

Answer 7

CPI is RPI but without interest rates added into it.

CPI is weighted price index so finances in weight reflects shifts in the spending patterns of households.

Question 8

How do you calculate CPI?

Answer 8

Divide the new data (P2) by the original one (P1), multiplying the result by 100

Question 9

What are 4 limitations of CPI as a measure of inflation?

Answer 9

1. Few households are ‘average’ so the cpi is not fully representative-
2. Spending patterns differ
3. Changing quality of goods and services- the prices rise may be due to improvements in quality/ performance of the product- better product for higher prices.
4. New products- slow to be updated

Question 10

What is demand pull inflation?

Answer 10

When there is a significant increase in demand for a scare amount of goods, so firms raise their prices as consumers are more willing and able to pay more and firms can maximise profits

Question 11

What are the 4 causes of demand pull inflation?

Answer 11

1. A depreciation of the exchange rate- WIDEC- consumers buy fewer imports whilst exports grow- shifts out AD- multiplier effect on the level of demand and output-inflation
2. Higher demand from a fiscal policy stimulus e.g. government lower tax rates- more disposable income- demand rises
3. Monetary policy stimulus e.g. lower interest rates- raising demand for spending on credit loans or mortgages- inflation
4. Fast growth in other countries- increase in disposable income in other countries- international trade as they import more- boost to U.K. exports overseas- shifts AD

Question 12

What do classical economists believe inflation is caused by ?

Answer 12

Too much money chasing too few goods and that governments can lose control of inflation if they allow the financial system to expand the money supply too quickly.

Question 13

What is cost push inflation?

Answer 13

Cost push inflation is a type of inflation caused by substantial increases in the cost of important goods and services where no suitable alternative is available.

Question 14

What are some examples of causes of cost push inflation?

Answer 14

1. Rising unit labour costs
2. Higher prices for important components/raw materials
3. A depreciation in the exchange rate causing a rise in import costs
4. An increase in business taxes e.g. VAT or environmental taxes such as carbon tax.

Question 15

What are some possible costs of inflation?

Answer 15

1. Cost of borrowing
2. Income redistribution
3. Falling real incomes
4. Negative real interest rates
5. Confusion and uncertainty
6. Business competitiveness
7. Risks of wage inflation

Question 16

What are some possible winners from high inflation

Answer 16

1. Workers with strong wage bargaining power- workers will be able to negotiate with their employers to bet higher wages. If inflation happens they will be in a better situation. These employers have certain assets that make them winners e.g. certain skills that only they can do
2. Debtors if real interest rates are negative- people will be earning money from banks and will have to pay less than what they borrowed
3. Producers if prices rise faster than costs- producers will be earning higher levels of profits in the short run (AD shifts out)

Question 17

What are some possible losers from high inflation

Answer 17

1. Retired on fixed incomes- significantly less purchasing power due to the incomes not changing in line with inflation- income inequality
2. Lenders of real interest rates are negative- give out more money than borrowed
3. Savers if real returns are negative- losing money year on year
4. Workers in low paid jobs- higher inflation could cause workers to struggle to afford goods due to incomes only changing yearly.

Question 18

What are the two solutions to control inflation?

Answer 18

1. Fiscal policy

2. Monetary policy

Question 19

What is fiscal policy?

Answer 19

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation’s economy. For example, raising income tax or VAT

Question 20

What is a limitation of using fiscal policy

Answer 20

Demand and output are lower which has a negative effect on jobs and real economic growth in the short term, affecting employment and investment opportunities, thus affecting productive potential, welfare payments etc.

Question 21

What is monetary policy?

Answer 21

Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.

AD is better controlled through monetary policy

Question 22

Limitation of using monetary policy?

Answer 22

1. Depends on the size of the interest rate change
2. Disincentive for businesses to expand/grow
3. Higher interest rates may cause the exchange rate to appreciate in value- SPICED- causing a fall in the cost of imported goods and services and a fall in demand for exports.

Question 23

Explain possible causes on demand-pull inflation

Answer 23

1. A growing economy- consumer confidence
2. Asset inflation
3. Government spending- government spends more prices go up
4. Inflation expectations- consumers demand more in the short run
5. More money in the system- an expansion of the money supply with two few goods to buy makes prices increase.

Question 24

Explain possible causes of cost-push inflation?

Answer 24

1. Higher prices of commodities e.g. oil
2. Imported inflation- WIDEC
3. Higher wages
4. Higher taxes
5. Profit-push inflation- if firms gain increased monopoly power they are in a position to push up prices to make more profit

Question 25

Possible solutions for cost-push inflation?

Answer 25

1. Wage controls
2. Supply-side policies
3. Increased government spending on education and training

Question 26

What are direct controls

Answer 26

“Direct controls” refer to any measure of governmental intervention which is directly aimed at increasing or decreasing some particular group of payments or receipts in the balance of payment.

Question 27

A government might choose to introduce direct controls on some prices and wages such as:

Answer 27

Public sector pay awards – the annual increase in government sector pay might be tightly controlled or even froze (this means a real wage decrease)- consumers have less purchasing power

The prices of some utilities such as water bills are subject to regulatory control – if the price capping regime changes, this can have a short-term effect on the rate of inflation- companies can no longer take advantage and charge extortionate prices for commodity goods.

Question 28

What are the two types of deflation?

Answer 28

1. Benign deflation

2. Malevolent deflation

Question 29

What is the benign deflation?

What diagram?

Answer 29

Falling prices in certain products due to technological advances across the economy (increasing supply- shifting too far right)

As shifts outwards

Question 30

What is the malevolent deflation?

What diagram?

Answer 30

Falling prices from significant downturn in economic activity I.e. a fall in AD. This may occur in the aftermath of a credit boom/bust as people seek to repay debts and reduce overall spending.

Could cause deflationary spiral- higher unemployment

AD shifts inwards

Question 31

What is the deflation spiral?

Answer 31

Falling prices and lower wages= fall in AD and lower confidence

(Opposite of wage price spiral)

Question 32

Problems of deflation?

Demand side

Answer 32

1. Discourages consumer spending- people delay purchases when there’s deflation as it will be cheaper in the future- high unemployment
2. Increased real interest rates- saving money gives a reasonable return. Consumers would prefer to save their disposable am income so AD shifts inwards
3. Real wage unemployment- real wages rise causing real wage unemployment- wage price spiral

Question 33

Problems of deflation?

Supply side

Answer 33

1. Increase real value of debt- debtors find it hard to pay back debt- less money for spending and investment
2. More difficult for relative prices and wages to adjust- lower consumer spending of certain goods and services because they are not increasing within the same percentage e.g. average prices or wages increasing by 3% could mean some goods 0% some 6%
3. Deflation can become entrenched and difficult to end- deflation can become the new norm- economic growth lowers so it is hard for businesses to earn profit