3.4 - Price Stability

• Real and Nominal Values:

  • A nominal value is something in money terms
  • A real value takes inflation into account
  • Basically, economists take inflation into account (with real values) to compare information about an economy over time, such as income and the rate of interest
• Can inflation be negative?

  Yes, the general price level basically falls over time.
• Consumer Price Index

  The government surveys the goods and services average UK families spend their money on.

  Known as a 'basket' of goods and services.

  It records the prices of all the goods and services in this basket every month. These figures are recorded in the CPI.

  To make the CPI accurate, the government uses a system called weighting. Each item in the 'basket' is given a weight, which represents its importance.
• If the rate of inflation falls, but is still positive, the price level is still rising. The price level only falls when the inflation rate falls below zero.
• Causes of Inflation

  Demand-Pull inflation:

  Happens when the total demand rises faster than the total (aggregate) supply in a country.

  One cause is increased incomes, as consumers are able to afford more goods and services. Could also happen during a boom.

  There is increased competition for these goods and services, which leads to higher prices.

  Most likely to happen when the economy is near to full employment. Available factors of production (including labour) are being fully used, so the economy cannot produce any more output in the short run.
• Cost-Push Inflation:

  Caused by higher costs of production = rise in price level. Firms pass costs of production to consumers to maintain profits.

  Costs of production include - wages, salaries, rent, business rates, interest on loans + fuel. Main ones are wages + wage costs like national insurance.

  A fall in productivity leads to a rise in average costs - higher prices

  Higher exchange rate = increase in price of inputs to production that are imported

  An increase in trade union power may also lead to higher wages being negotiated = rise in inflation. Wage-price spiral can worsen inflation
• Consequences of Inflation (Consumers)

  Loss of Consumer Confidence -

  Difficult to decide how to prioritise spending income - uncertainty may stop ppl buying things

  
  

  Shoe leather costs -

  Consumers + firms have to compare prices - time + effort to find best deals

  
  

  Real incomes may fall -

  Income may rise at slower rate than inflation - consumers have less purchasing power.

  
  

  Consumers who are debtors gain -

  Real value of debt falls. Opportunity cost of paying back money falls.

  
  

  Income redistribution -

  Some workers (with stronger trade unions) negotiate higher wages.
• Consequences of Inflation (Producers)

  Menu costs -

  Firms have to update price lists more often when there is inflation - can increase production costs (e.g. printing new catalogues)

  
  

  Producers as creditors -

  Include firms like banks that are owed money. Real value of their loans may fall - get less money back

  
  

  Less likely to invest

  
  

  Labour market disputes -

  May have to spend more time negotiating wage rises with workers.

  More likely strikes.

  
  

  Lower exports -

  If inflation in UK = higher than other countries, UK goods = more expensive - overseas consumers buy less from the UK
• Consequences of Inflation (Savers)

  Savings will lose value in real terms during times of inflation.

  Savers are losers in times of inflation
• Consequences of Inflation (Government)

  Government spends more as a provider of benefits:

  Benefits rise in line with inflation

  Government as debtor:

  Real value of the nation debt can fall if there is inflation - may benefit government

  Government as employer:

  Inflation leads to pressure on the government to increase wages for employees (e.g. teachers and NHS). Increased government spending.

  Tax Revenue:

  VAT and income tax increase - higher prices = higher VAT. Higher incomes, people may be put in a higher tax bracket.
• Inflation

  Inflation (especially high rates) can have drastic consequences for an economy. Therefore, it is essential that government policy includes the aim of controlling inflation.
• Consequences of Inflation - Summary

  Consumers - loss of confidence, shoe leather cost, fall in real incomes, consumer debtors gain, income redistribution

  Producers - menu costs, labour market conflicts, producer creditors lose, reduced business confidence

  Savers - value of savings falls

  Government - gains as debtor, spends more on benefits/labour, more tax revenue
• Inflation definition

  A sustained rise in the general price level over time
• Price stability

  When the general level of prices stays constant over time, or grows at an acceptably low rate
• Consumer Price Index Definition

  Method used to calculate the rate of inflation