2.1.2 Inflation

• Define inflation

  -the sustained increase in the general price level of goods and services in an economy over time

  
  

  -decreases purchasing power
• Define deflation

  Deflation is the opposite of inflation, characterized by a sustained decrease in the general price level.

  
  

  It increases the purchasing power of money but can discourage spending and investment.
• Define Disinflation

  Disinflation occurs when the rate of inflation declines but remains positive.

  
  

  Prices are still rising, but at a slower rate than before.
• Consumer Prices Index

  It measures household purchasing power with the family expenditure in survey

  
  

  The survey finds out what consumers spent their income on - a basket of goods is created

  
  

  The goods are weighted according to how much income is spent on each item
• CPI (2)

  -CPI is a widely used measure of inflation in the UK.

  
  

  -It tracks changes in the prices of a basket of goods and services purchased by an average household.
• New index formula

  New value/Original value (Base year where values were more stable) 100
• Calculating the Rate of Inflation Using the Consumer Prices Index (CPI)

  CPI is a widely used measure of inflation in the UK.

  
  

  It tracks changes in the prices of a basket of goods and services purchased by an average household.

  
  

  CPI is always increasing gradually

  
  

  Examples:

  Mortgages (not everyone has a mortgage) or housing costs
• Calculating CPI Inflation

  CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100.
• Limitations of CPI in Measuring Inflation

  Substitution Bias

  
  

  CPI assumes constant consumption patterns, whereas consumers often adjust their purchases in response to changing prices.

  This can lead to an overestimation of inflation.

  
  

  Quality Changes

  
  

  CPI may not adequately account for quality improvements in goods and services over time.

  This can result in an overestimation of price increases.
• Limitations of CPI (2)

  -Errors/ inaccuracies in data

  
  

  -Time lags: The CPI is slow to respond to new products in markets

  
  

  -CPI basket is not fully representative of all consumers
• Retail Prices Index (RPI) as an Alternative Measure of Inflation

  RPI is another measure of inflation in the UK that includes a broader range of expenditures than CPI.

  
  

  It is used for various purposes, including index-linked bonds and some pension calculations

  
  

  RPI is what's being spent
• Retail Prices Index (RPI) as an Alternative Measure of Inflation (2)

  Differences from CPI

  
  

  RPI tends to produce a higher inflation rate than CPI because it includes housing costs and uses a different formula.

  
  

  Broader range of expenditures
• What are substitute items

  -Anything which has multiple substitutes will be weighed less

  
  

  -Anything without substitutes will be weighted more

  
  

  E.g:Milk is weighted less as there are many options and Petrol is given a high weighting as there are few substitutes
• What is the basket of goods

  Both measurements are based upon a basket of goods and services which is designed to represent the typical purchases of consumers throughout the UK

  
  

  There are around 700 items in the basket of goods and services
• Limitations of the basket of goods

  -Few people will fit in the definition of 'average' as defined by the basket of goods and services

  
  

  -For many households, the monthly mortgage payment represents their biggest item of expenditure but it's excluded from the RPI calculations
• Causes of Inflation (1)

  Demand-Pull Inflation

  
  

  Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, leading to upward pressure on prices.

  
  

  There is too much money chasing too few goods and services
• Causes of Inflation (2)

  Cost-Push Inflation

  
  

  Cost-push inflation arises when production costs increase, causing firms to raise prices to maintain profitability.

  
  

  Firms typically do this to protect profit margins
• Causes of cost push inflation

  -Wage increases

  -Higher raw material costs

  -Higher taxes

  -Higher import prices

  -Natural disasters
• Causes of inflation (3)

  Growth of the Money Supply

  
  

  An increase in the money supply, not matched by a corresponding increase in economic output, can lead to excess demand for goods and services and result in inflation
• Growth of money supply

  The money supply is a measure of the amount or stock of money in the economy
• Different definitions of money supply

  -MO (narrow money) which includes notes and coins in circulation and some other liquid assets

  
  

  -Broad Money includes a wider definition of money including MO, bank account deposits and other liquid assets
• How the government can increase the money supply

  -Printing more notes through the Bank of England

  
  

  -Use quantitative easing to create money electronically

  
  

  -The Bank of England can buy bonds off financial institutions creating liquidity
• Effects of Inflation on Consumers

  Inflation erodes the purchasing power of money, reducing the real value of savings.

  
  

  Fixed-income earners may experience reduced real incomes.

  
  

  People on fixed pensions may find it more challenging to maintain their standard of living.
• Effects of inflation on firms

  Firms may face rising production costs, reducing profit margins.

  
  

  They may adjust prices upward to maintain profitability.
• Effects of inflation on Government

  Inflation can increase the cost of servicing government debt, diverting resources from other public spending priorities.

  
  

  Tax brackets may not be adjusted for inflation, resulting in "bracket creep" and higher tax burdens.
• Effects of inflation on Workers

  While workers may see nominal wage increases, their real wages may decline due to inflation.

  
  

  Labor unions may negotiate for higher wages to keep pace with rising prices.
• Causes of demand pull inflation

  -Reduced taxation

  -Lower interest rates

  -A general rise in consumer spending

  -A weak exchange rate

  -Fast growth in other countries

  -General rise in confidence/ expectations of future growth

  -Certainty

  • Gov't spending: expansionary fiscal policy (e.g ↑ gov' t spending on projects like infrastructure improvements, tax cuts, transfer payments can boost AD)
• Reasons for continued low inflation

  -Increased competition in markets

  
  

  -Success of Bank of England in controlling AD

  
  

  -Strong exchange rate has kept imports prices low
• Reasons for continued low inflation (2)

  -Effects of globalisation- cheaper imports

  
  

  -Rising productivity + new technology

  
  

  -A fall in workers expectations of inflation
• Policies to control inflation

  Monetary policy - Higher interest rates. This increases the cost of borrowing and discourages spending. This leads to lower economic growth and lower inflation.

  
  

  Tight fiscal policy - Higher income tax and/or lower government spending, will reduce aggregate demand, leading to lower growth and less demand pull inflation
• Policies to control inflation (2)

  Supply side policies - These aim to increase long-term competitiveness, productivity and innovation

  
  

  Direct controls - public sector pay controls. Capping or other regulation of prices of utilities e.g water bills
• Stagflation

  An economy experiences slow economic growth, rising unemployment and high and rising inflation.