price stability

• general price level is the measure of overall prices of goods and services in an economy at a particular point of time
• price stability is when the general price level stays constant over time or grows at an acceptably low rate
• inflation is a sustained rise in general price level over time which causes a fall in purchasing power of money and increases cost of living
• rate of inflation is the percentage rise in general price level over time

  • if positive then general price level is rising
  • if negative then general price level is falling
• nominal value is the value of something in money terms, whereas real value takes inflation into account (it refers to the goods and services thta can be bought with that money)
• real rate of interest takes inflation into account (can be negative)
• inflation is meassured using the CPI (consumer price index)

  • the government takes a survey to determine the goods and services families spend money on (known as 'basket' of goods)
  • price of basket is recorded every month
  • index is used as percentage and starts at 100
  • to make CPI accurate, government does weighting (each item is given a 'weight' representing its importance
• causes of inflation:

  • too much demand
  • rise in costs
• demand-pull inflation:

  • aggregate demand rises and supply does not match the increase
  • likely to happen when near full-employment (all available factors of production are in use)
  • could be caused by monetary inflation (rise in money supply enables consumers to demand more)
• cost-push inflation:

  • caused by high costs of production leading to prices rising
  • in order to maintain profits, first must raise prices
  • main cost is wages
  • when wages rise faster than productivity, cost per unit of output will rise
  • stronger power of trade unions made cost-push inflation more likely
  • could be caused by imported inflation (higher import costs cause inflation)
• wage-inflation cycle:

  1. initial rise in general price level
  2. workers demand higher wages to compensate
  3. wages paid to workers rise
  4. cost of production rises
  5. firms increase prices to compensate for increase in costs
  6. general price level rises further
• consequences of inflation for consumers:

  • loss of consumer confidence
  • shoe leather costs (extra time and effort looking for cheaper goods)
  • real incomes may fall (if nominal income stays the same in inflation, cost of living increases and standard of living falls, HOWEVER some may have index-linked incomes)
  • consumers who are debtors gain (real value of debt decreases)
  • income redistribution problems (debtors gain, savers lose, those with strong trade unions may gain, those with little bargaining power in low-paid jobs may have a decrease in real wages)
• consequences of inflation for producers:

  • more flexibility
  • menu costs (as prices rise, producers adjust price lists)
  • labour market conflicts
  • unemployment (inflation makes UK market less competitive, leading to cyclical unemployment)
  • producers lose as creditors (the real value of repayed loans is lower)
  • producers lack business confidence (less likely to invest, stunting economic growth)
• how does inflation increase firms flexibility?

  • low levels of inflation gives producers flexibility for relative prices to adjust
  • this enables them to become more competitive
  • increasing prices is less noticable when there is inflation
  • this can lead to more profit and capital available for investment
• how does inflation cause labour market conflicts?

  • inflation decreases purchasing power of money
  • workers and trade unions demand more wages
  • they may ask for a rise above the rate of inflation to take account for future inflation
  • this can lead to strikes
• consequences of inflation for savers:

  • inflation makes purchasing power of money decrease
  • if money is kept as savings, those savings will use value in real terms during times of inflation
• consequences of inflation for the government:

  • government gains as debtor
  • spends more as a provider of benefits (benefits are index-linked and therefore rise with inflation)
  • spends more as major employer (due to workers demanding wage rises)
  • recieves more in tax
  • government policies to combat inflation
• how does inflation affect taxation for the government?


  • increased VAT and income tax will generate more finance to spend on extra money for benefits
  • however some taxes are set per unit and are not index-linked (e.g. alcohol, tobacco) therefore the value of revenue from these taxes will fall in real terms even when prices increase