Inflation

• Inflation is a sustained increase of the average price levels over a period of time.
• Inflation is measured by the annual percentage change in the level of prices given by the consumer price index.
• Deflation is a sustained fall in the general price level over a period of time. The rate of inflation becomes negative.
• Disinflation is when the rate of inflation is decreasing but prices are still rising, just at a slower rate.
• Consumer Price Index (CPI) is the main measure of inflation for the UK which is used to compare us to other countries.
• Retail Price Index (RPI) is the CPI + housing costs
• The two causes of inflation are: Cost push inflation and demand pull inflation.
• Cost push inflation is when the cost of production increases leading to an inward shift in the SRAS curve. Firms raise prices to protect profit margins. Due to these higher prices, higher wages are demanded which in turn leads to higher production costs. This is known as the wage-price spiral.
• Demand pull inflation is when there is excess aggregate demand. Firms respond to high demand by raising their prices leading to fast growth and high levels of consumer spending. AD=C+I+G+(X-M). When C, I, G or X increases, so does inflation.
• Costs of inflation: 1) Money loses value and people lose confidence as the value of current savings is reduced. 2) Consumers and businesses on fixed incomes lose out because their real incomes fall. 3) Higher interest rates which reduces economic growth. 4) Shoe leather costs - Walking to find banks that will give the best deals. 5) Menu costs - companies keep updating prices to reflect the change in raw material costs which is time consuming. 6) Psychological costs - needing to pay for essential goods and services.
• Deflationary Spiral - Prices fall causing consumption to fall because people see prices falling and want to wait and get the good at a lower price as they know it will fall by more. This leads to firms lowering their prices more to incentivise spending. This causes unemployment because firms have no revenue. This increases inequality as the rich still have jobs and prices continue to fall.