Macro Unit 3- Inflation Flashcards
What is inflation?
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%
What is purchasing power?
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.
What is disinflation?
Disinflation is when there is a lower inflation rate meaning prices rise more slowly
What is deflation?
Deflation is the reduction of the general level of prices in an economy.
What are the 2 methods of measuring inflation in the U.K.?
- Consumer Price Index (CPI)
2. Retail Price Index (RPI)
What is RPI?
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.
What is CPI?
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.
How do you calculate CPI?
Divide the new data (P2) by the original one (P1), multiplying the result by 100
What are 4 limitations of CPI as a measure of inflation?
- Few households are ‘average’ so the cpi is not fully representative-
- Spending patterns differ
- 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.
- New products- slow to be updated
What is demand pull inflation?
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
What are the 4 causes of demand pull inflation?
- 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
- Higher demand from a fiscal policy stimulus e.g. government lower tax rates- more disposable income- demand rises
- Monetary policy stimulus e.g. lower interest rates- raising demand for spending on credit loans or mortgages- inflation
- 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
What do classical economists believe inflation is caused by ?
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.
What is cost push inflation?
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.
What are some examples of causes of cost push inflation?
- Rising unit labour costs
- Higher prices for important components/raw materials
- A depreciation in the exchange rate causing a rise in import costs
- An increase in business taxes e.g. VAT or environmental taxes such as carbon tax.
What are some possible costs of inflation?
- Cost of borrowing
- Income redistribution
- Falling real incomes
- Negative real interest rates
- Confusion and uncertainty
- Business competitiveness
- Risks of wage inflation
What are some possible winners from high inflation
- 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
- Debtors if real interest rates are negative- people will be earning money from banks and will have to pay less than what they borrowed
- Producers if prices rise faster than costs- producers will be earning higher levels of profits in the short run (AD shifts out)
What are some possible losers from high inflation
- Retired on fixed incomes- significantly less purchasing power due to the incomes not changing in line with inflation- income inequality
- Lenders of real interest rates are negative- give out more money than borrowed
- Savers if real returns are negative- losing money year on year
- Workers in low paid jobs- higher inflation could cause workers to struggle to afford goods due to incomes only changing yearly.
What are the two solutions to control inflation?
- Fiscal policy
2. Monetary policy
What is fiscal policy?
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
What is a limitation of using fiscal policy
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.
What is monetary policy?
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
Limitation of using monetary policy?
- Depends on the size of the interest rate change
- Disincentive for businesses to expand/grow
- 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.
Explain possible causes on demand-pull inflation
- A growing economy- consumer confidence
- Asset inflation
- Government spending- government spends more prices go up
- Inflation expectations- consumers demand more in the short run
- More money in the system- an expansion of the money supply with two few goods to buy makes prices increase.
Explain possible causes of cost-push inflation?
- Higher prices of commodities e.g. oil
- Imported inflation- WIDEC
- Higher wages
- Higher taxes
- Profit-push inflation- if firms gain increased monopoly power they are in a position to push up prices to make more profit
