Price inflation

Question 1

Define

inflation

Answer 1

A sustained or ongoing increase in the general level of prices in an economy.

Question 2

Define

hyperinflation

Answer 2

An inflation rate that is very high and out of control, as result of which confidence in a currency can be lost because its real value is eroded very quickly.

Question 3

Define

Consumer Price Index (CPI)

or

Retail Price Index (RPI)

Answer 3

A measure of inflation based on changes in the average price of a basket of goods and services purchased by a ‘typical’ household and which expresses these average prices as an index number series.

CPI and RPI are sometimes used in addition to one another to measure inflation.

Question 4

What is the difference between CPI and RPI?

Answer 4

The methodology used for each index series is the same, but the products they include and the types of consumer they cover can differ. As a result they can provide slightly different measures of inflation.

Question 5

How do you calculate price index?

Answer 5

Year 0 (base year)

1. Identify the basket of goods and services purchased by the ‘typical’ family
2. Monitor the ‘average’ price of each item in the basket at a sample of different retail outlets
3. Monitor how much the ‘typical’ family spends on each item in the basket
4. Weight the average price of each item by the proportion of household expenditure spent on it
5. Add up all the weighted average prices. This is the price of the basket.
6. Set the total weighted average price of the basket equal to 100. This is the price index.

Year 1 onwards

1. Repeat steps 1 to 5
2. Divide weighted average price by base year total average price and multiply by 100. This is the price index.
3. Minus 100 to give % inflation rate

Question 6

What are the three main uses of price indicies?

Answer 6

1. As an economic indicator
2. As a price deflator
3. Indexation

Question 7

Define

indexation

Answer 7

The automatic adjustment of a monetary variable, such as wages, taxes, welfare or pension benefits, by the increase in the consumer or retail prices index, so that its value rises at the same rate as inflation, i.e. so that the real value of the variable is kept constant.

Question 8

What are some problems with price indicies?

Answer 8

1. A CPI must take into account:

• The changes in the ‘typical’ household and the goods and services it buys
• Changes in the quality of products
• How/where households buy products (e.g. online shopping, television shopping channels

2. Deciding how and when to make these changes is difficult.
3. International comparisons of consumer price inflation are difficult to make because household composition and spending patterns can differ significantly by country.

Question 9

What causes inflation?

Answer 9

Economists today tend to agree that the main cause of inflation is ‘too much money chasing too few goods’

i.e. if the money supply increases at a faster rate than the aggregate supply of goods and services then the general level of prices will rise

There are three main types of inflation:

• Demand-pull inflation
• Cost-push inflation
• Imported inflation

Question 10

What monetary rule can a government follow if it wants to keep inflation low and stable in its economy?

Answer 10

The government should only allow the supply of money to expand at the same rate as the increase in real output or real GDP over time.

Question 11

Define

stagflation

Answer 11

An economic situation in which both price inflation and unemployment are rising at the same time.

This may be caused by government policy if the monetary rule is not followed.

Question 12

What is demand-pull inflation?

Answer 12

A persistent increase in the general level of prices resulting from a continued excess of demand over supply.

An increase in aggregate demand will cause market prices to increase and inflation to rise if firms are unable to increase the supply of goods and services at the same rate as demand.

To finance an increase in aggregate demand, consumers and firms may borrow more from banks and/or the government can issue more notes and coins. Both methods involve increasing the money supply.

Question 13

What is cost-push inflation?

Answer 13

Persistently rising general price levels caused by increasing production costs passed on to consumers.

The cost of producing goods and services may rise due to:

• workers demanding increased wages not matched by increased productivity
• rise in costs of other factors of production

However, as wages rise the demand for labour will tend to fall and workers could be made unemployed. To prevent a rise in unemployment the government may expend the supply of money to boost aggregate demand.

Inflation may cause a wage-price spiral.

Question 14

What is imported inflation?

Answer 14

A sustained increase in the prices of products bought from overseas producers either resulting from their rising costs or a fall in the exchange rate against overseas currencies.

Question 15

What is a wage-price spiral?

Answer 15

An economic situation in which workers demand higher wages to compensate them for the impact of rising inflation on the real value of their earnings and in so doing force producers to pass on increased wage costs to consumers in higher prices, resulting in even higher wage demands, and so on.

Question 16

What are the benefits of low and stable inflation?

Answer 16

• It encourages consumers to buy goods and services sooner rather than later
• It reduces the real cost of loan repayments
• A low and stable demand-pull inflation will tend to boost profits
• Expectations that inflation will be low reduces demands for higher wages for workers
• If money wages rise by less than the inflation rate each year, the real cost of employing workers will fall for firms and may encourage them to increase their demand for labour

Question 17

What are the costs of inflation to an individual?

Answer 17

• Inflation erodes the purchasing power of money
• Inflation reduces the real income of an individual
• People will face hardship if they are unable to increase their money income/nominal income at the same rate as price inflation
• People who save or lend money may be badly affected by inflation if the interest rate is lower than the rate of price inflation

Question 18

What are the costs of inflation to an economy?

Answer 18

• It imposes additional costs on firms and reduces profit margins
• It reduces the competitiveness of exports
• It creates economic uncertainty. Consumers, firms and governments will be uncertain about their future costs and the impact rising inflation could have on their incomes and revenues. Firms may cut their investment and consumers their spending.

Question 19

Define

deflation

Answer 19

A fall in the general level of prices in an economy. If the general level of prices is sustained and continues to fall over a long period of time caused by a lack of demand it is referred to as a malign deflation.

Question 20

Define

disinflation

Answer 20

A slowdown in the rate at which the general price level is rising over time.

Question 21

What possible reasons are there for falling product prices?

Answer 21

• market supply increases relative to demand
• competition between firms to supply products increases
• labour productivity rises, increasing output and reducing average costs
• technological advance has reduced their costs of production
• market demand for them has fallen

Question 22

How can falling product prices be good/bad?

Answer 22

Increasing supply, competition, productivity and technological advance are good things for an economy and consumers, and have reduced the prices of many products over time, such as mobile phones, televisions, cars, holidays and clothing, in many countries

However, when falling product prices become widespread and prolonged due to a slump in aggregate demand, the result is malign deflation.

Question 23

What consequences/changes will occur during a sustained or malign deflation?

Answer 23

• Consumers delay spending as they wait for prices to fall further
• Stocks of unsold goods accumulate so firms cut their prices and this reduces their profits and incentive to invest
• Firms cut their production and reduce the size of their workforces
• Household incomes fall as unemployment rises, further reducing demand
• The value of debts held by people and firms rise in real terms as prices fall and this increases the burden of making loan repayments
• Firms stop investing in new plant and machinery as demand falls and the cost of borrowing rises
• The real cost of public spending rises but tax revenues fall as economic activity slumps; this means the government must borrow more money despite the rising real cost of doing so
• Eventually the economy goes into a deep recession as demand, output, the demand for labour, and incomes continue to fall. Many firms may go out of business because they are unable to make any profit no matter how much they cut their prices by as consumers simply continue to delat their spending further.

Question 24

How may a government attempt to stop deflation?

Answer 24

• Cut interest rates (however, if prices are falling this means real interest rates will be rising, even if the nominal interest rate is zero)
• Print more curreny (increase money supply)
• People and firms may still not increase their own spending, but government can use the money to fund projects that will draw more people back into employment
• Expansionary fiscal policy - tax cuts on incomes and profits may boost demand