Measures of Economic Performance - Inflation Flashcards
Inflation
Inflation – a sustained increase in the general price level.
Deflation – a sustained decrease in the general price level.
Disinflation – a reduction in the rate of inflation (the inflation rate falls but
the price level is still rising, but at a slower rate).
Cost-of-living - a measure of changes in the average cost for a household of
buying a basket of different goods and services.
Inflation target – a target set by the government which the central bank
should aim to achieve eg in UK it is CPI inflation = 2% +/- 1% point
Calculating inflation using the Consumer Price Index (CPI)
The ‘headline’ rate of inflation is the annual % change in the CPI. The
CPI tracks changes in the prices of a basket of goods and services
purchased by an average household. It is expressed as an index number.
The formula for calculating CPI inflation is:
CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100
Basket of goods and services = things a typical household buys; updated
each year to keep it relevant. Price survey – prices of the goods and
services in the basket are monitored each month. The price of each
representative good/service in the basket is weighted according to the
proportion of income a typical household spends on it
Other measures of inflation
CPIH = similar to CPI but also monitors owner occupier housing costs (OOH), in its
basket. These are the costs associated with owning, maintaining and living in one’s own
home.
RPI – Retail Price Index - the basket of goods/services includes some items not in the
CPI, such as council tax & mortgage interest payments; it is often used to calculate
increases in welfare benefits, pensions, index-linked bonds and wage negotiations; in a
period of rising interest rates it typically gives a higher rate of inflation than the CPI
‘Core’ inflation – sustained increase in prices of goods in the basket, excluding goods
such as energy, food, alcohol and tobacco which can have volatile prices.
Limitations of the CPI inflation measure
- CPI inflation is only calculated for an ‘average’ family
- It does not consider quality of goods/services
- Needs regular updating to reflect changes in patterns of spending
- International comparisons may not be accurate if other countries do not calculate
inflation in the same way
Costs of inflation
Shoe leather costs: costs of shopping around when prices change rapidly
Menu costs: costs of redoing menus, parking changes, price labels & lists
Fall in real incomes: if wages do not keep pace with prices, real incomes
fall
Uncertainty: consumers and businesses may reduce their spending
causing unemployment and weaker growth
Redistributional effects: savers get a lower real rate of return, those on
fixed incomes lose out, workers in the gig economy may not be able to
negotiate real wage increases; fiscal drag increase tax paid if thresholds
are frozen
Loss of international competitiveness: weaker current account on the
Balance of Payments as exports become relatively more expensive and
imports relatively cheaper
Increase in inflation expectations – people will aim for bigger pay rises if
they expect higher inflation, which can add to business costs and prices
Danger of wage-price spiral – if workers demand big pay rises
Benefits of a low rate of inflation
- A low but steady rate implies aggregate demand is running ahead of aggregate
supply, incentivising business investment and growth - Reduces the real value of debt
- Allows negative interest rates
- Helps labour markets work more efficiently without a need to cut nominal wages
because real wages can fall - Makes malign deflation less likely
Causes of inflation – demand pull
Demand-pull
inflation is inflation
caused by excess AD
in the economy.
Producers can raise
prices and increase
their profits
Causes of inflation – cost-push
Cost-push inflation is
inflation caused by
increases in the costs of
production in the economy.
Can cause stagflation –
when economy stagnates
as price level rises
Causes of demand-pull inflation
- Lower interest rates
- Lower income tax
- Rapid income growth
- High consumer confidence
- Positive wealth effects
- Easy credit (cheap and accessible credit)
- Depreciation of the currency
Causes of cost-push inflation
- Rapid wage rises/higher labour costs
- Skill shortages
- Increasing input costs (raw material, energy)
- Higher commodity prices
- Food price inflation
- Indirect tax rises
- Depreciation of currency (imported inflation)
Causes of inflation - growth of the money supply
Monetarists argue that inflation is caused by excessive growth of the
money supply - ‘too much money chasing too few goods’.
Firms and consumers may spend their excess money, thus raising AD; the
demand for labour could rise because it is derived from demand for goods
increasing wages and costs of production.
Anticipated v unanticipated inflation
Inflation tends to be more damaging when is it unanticipated; the costs of
inflation to economic agents are higher when there is an inflation shock eg
a sudden sharp increase in energy or food prices.
Having an inflation target, as is the case in the UK, can help with
‘inflationary expectations’ and ‘anchor’ inflation to the 2% target.
Causes of demand-side deflation – fall in AD
Deflation caused by
fall in AD ie inflation
caused by a lack
of AD in the
economy.
Producers have to
reduce prices and
their profits fall
Causes of supply-side deflation – increase in AS
Deflation caused by an
increase in short run
aggregate supply ie
deflation caused by
decreases in the costs of
production in the economy;
Costs of deflation
- Lower AD causes over supply
- Lower prices for goods and services cuts cash flow and profits for
businesses; consumers may delay their spending; businesses may cut
investment - Businesses reduce production; cyclical unemployment rises
- Rise in real value of debt
- Real interest rates may rise reducing consumption and investment
Causes of ‘malign’ deflation
- Negative demand shock (eg credit crunch in global financial crisis 2008-9)
- Global recession
- Appreciation of currency causing fall in net exports
- Falling asset prices (negative wealth effect)
- Contractionary fiscal and/or monetary policy
Causes of ‘benign’ deflation
- Technological advances
- Improvements in productivity
- Falling price of commodity prices
- Falling price of energy prices
- Globalisation/economies of scale
- Cheaper/more skilled labour (perhaps from immigration)
Benefits of deflation
- Falling prices for consumers
- Increase in real incomes
- Increased spending power for those on fixed incomes
- Improved international competitiveness
- Falling asset prices make housing more affordable for first time buyersI
