Theme 2 - Inflation Flashcards
What is 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.
How is rate of inflation measured?
By an annual percentage change in consumer prices. Government have a target of 2% +/- 1%
It is the job of the Bank of England to set monetary policy so that at inflationary pressures are controlled, and the economy stays on target.
Why would the individual economic agents want to know inflation?
1) households: to prioritise what they’ll spend their income on. Plan and budget.
2) firms: calculate any changes in the cost of production, set prices of their goods, workers want higher wages.
3) Government: they want to stay on target, reduce inflation, know the rate of benefits to adopt.
Consumer price index:
Is a measure of the general level of prices in the UK, adopted as the governments inflation target since 2003.
How is the rate of inflation measured?
- a base year is selected and a family expenditure survey is carried out across 40,000 households.
- a representative basket of goods and services used and weights are attached to each item based on the survey results.
- government officials take the prices of thousands of goods around the country and gather the data together to find the rate of inflation.
Alternative method measuring inflation: retail price inflation (RPI)
CPI replaced the RPI as it was measured in the same way as other countries which made it easier to compare the rates. It also measured the other macroeconomic policies better than RPI.
Similarities between the CPI and RPI:
- both measures set out to calculate the overall price level at different points in each time.
- each based on a basket of goods and service.
- show how the general level of prices has changed relative to the base year.
Common failing of the RPI and CPI:
*both use fixed weights to calculate the overall index - due to the weights being fixed they don’t pick up this substitution effect so this substitution effect so the cost of living may be calculated as being higher than it truly is.
Differences between the RPI and CPI:
- the goods in the baskets vary, the RPI includes housing costs but the CPI doesn’t.
- different types of households whose expenditure patterns are considered change.
Limitations of the CPI:
- the CPI is not fully representative: it represents the ‘average’ household so inaccurate for ‘non-typical’ households.
- spending patterns: single people spend differently to family households.
- changing quality of goods and services:if the price increases it may be due to an improvement in quality.
- new products: CPI is slow to respond to new products and services.
3 main causes of inflation:
- cost-push inflation: caused by increases in cost of production. Increases arise mainly through increased wages, imports and raw materials and taxes.
- demand-pull inflation: inflation is caused by an increase of spending in the economy. Increase in AD pulls the prices up as AD shifts right.
- increase in the money stock: persistent inflation occurs when money stock grows more rapidly than the real output of the economy. If the supply of money in the economy increases, firms and households have excess cash.
Why is high inflation an economic problem?
6 points
- inequality: regressive effect on lower income families.
- falling real incomes
- negative real interest rates
- cost of borrowing increase
- business competitiveness decreases
- increased business uncertainty impacts investment.
Macroeconomic policies to control inflation:
1) fiscal policy: a tightening fiscal policy would include less spending on public and merit goods.
2) monetary policy: higher interest rates may cause the currency to appreciate.
3) supply side policy: increases productivity, competition and innovation.
4) direct controls: public sector pay controls the capping of utilities such as water bills.
What is hyperinflation?
When inflation reaches exceptionally high and accelerating levels. It occurred in Zimbabwe in 2013 where inflation was at 230,000,000%
What is deflation?
A persistent fall in the general price level of goods and services.
