3.4 Price Stability

• ''Price Stability'' is defined as ''when the general levels of prices stay constant over time, or grows at an acceptably low rate.''
• The 'general level of prices' is a measure of the overall prices of goods + services in an economy, at a particular time; if the general level of price remains constant or grows at only a slow rate, then price stability has been achieved.
• 'Inflation' is defined as ''a sustained rise in the general price level over time''. This means that on average prices have risen as a whole over time, which will be reflected by a rise in 'the general level of prices'.
• Price stability in the UK is when inflation is between 1-3%. The main benefit of price stability is certainty --> businesses will have more certainty in relation to price rises (+ wage rises) in the future. With less uncertainty there will be less instability and businesses are more likely to have the confidence to invest more.
• The 'rate of inflation' is defined as ''the percentage rise in the general price level over time''
• The difference between price level and inflation is that price level is the overall level of prices in an economy, whilst inflation is how much those prices change by. As long as the rate of inflation stays positive (even if the rate of inflation still falls), then the general price levels will continue to rise. *The overall general price level falls ONLY when inflation is NEGATIVE* (see table in notes)
• 'Real' values are values after taking into account the effects of inflation. (In order to calculate something in 'real' terms, you must deduct inflation.)

  'Nominal' values are the money value of something.

  For example, if a worker receives a 7% pay rise when inflation is 5% then the nominal value rises by 7%, but in 'real' terms, pay rises by 2%.
• Inflation in the UK is measured using the consumer price index (CPI). This is defined as ''the method used to calculate the rate of inflation''. CPI is a weighted price index (weighted according to data importance).
• An 'index' means that at the start of the time period in which inflation is recorded, a base year is established with the CPI given the number 100 (at this time period). This means the general price level is set to 100 in the base year. *Any changes in the general price level can then be measured by looking at how the data changes from the base year*.

  For example, (to show how it is a 'weighted' index, as more importance is attached to those items which we spend more money on) if 40% of house hold incomes are spent on food, then 40% of the price changes in CPI must be made up of food items.
• Summary of how the consumer price index (CPI) works:

  (1). A survey of households is undertaken, to find what they spend their money on. --> (2). A typical ''basket'' of goods is then chosen. This contains around 600 products which an average ''household'' buys. --> (3). The prices of these 600 products are then recorded at around 200 different places *about 120,000 items of data overall* --> (4). These price changes are then compared to a base year where all the data is set to 100. Percentage changes are then worked out.
• Inflation reduces the PURCHASING POWER of people's incomes:

  E.g. Impact on prices after the rate of inflation is at 4%:

  Current After inflation

  Tea £1.70 (x1.04) =£1.77

  Bread £1.10 (x1.04) =£1.14

  Fish £4.70 (x1.04) =£4.88

  Washing powder £6.20 (x1.04) =£6.45
• 'Demand-pull' inflation is a cause of inflation. This occurs when there is ''too much money, chasing too few goods''. With demand exceeding supply, goods become scarce in the economy, and prices rise in order to 'ration' demand. *see diagram in notes*
• 'Cost-Push' inflation is a cause of inflation. A rise in costs of production leads to a reduction in firms' profit. Firms then respond by increasing prices --> prices then rise in order to cover the costs of production. *see diagram in notes*
• A benefit of the impact of inflation on consumers is for debtors -> people with large debts benefit from high rates of inflation... In 'real' terms the value of their debt falls -> this makes it easier to pay off -> In the long-term, they will have more disposable income and purchasing power -> results in better standards of living.
• A negative of the impact of inflation on consumers is falling 'real incomes'. In the event of high inflation, falling 'real' incomes will mean that the purchasing power of consumer's incomes will fall -> Consumers are unable to afford as many goods + services -> standard of living will fall.
• In judgement, the impact of inflation on consumers will depend upon how high inflation is, as it may not be significant enough to make a drastic change.
• A benefit of the impact of inflation on producers is that there is greater flexibility for firms. (A certain level of inflation is beneficial, but too much is a problem). At times when inflation is low (e.g. 2%), firms can increase their prices without consumers noticing -> Firms then gain increased profits -> firms can now spend more on research + development, and investment -> By investing in more capital equipment, firms will expand.
• A negative of the impact of inflation on producers is that there is a loss of international competitiveness. If firms are exporters and sell their goods overseas, inflation can be a huge issue. If inflation in the UK is higher than in other competitor nations, then the UK exports will be less competitive -> this means fewer will be sold -> economic growth + employment may fall.

  In summary, export sales fall -> firms lose demand -> workers may be fired -> rise in cyclical unemployment -> prevents economic growth.
• In Judgement, the impact of inflation on producers will depend upon how high inflation is relative to inflation in other competitor countries.
• A negative of the impact of inflation on savers is loss of money value in 'real' terms. Inflation reduces the purchasing power of money. This is because during times of high inflation, the purchasing power of savings is reduced (the savings lose value) -> this means savers have less wealth -> long-term decrease in standards of living.
• A condition when inflation has less impact on savers is dependent on interest rates. If the interest rate at which the saver receives is higher than the rate of inflation, then they will not see the purchasing power of their money fall.
• In judgement, the impact of inflation on savers will depend upon how long inflation remains high for.
• A benefit of the impact of inflation on the govt. is that they will receive more tax revenue. As indirect taxes (such as VAT) are added to the price of goods and services, as prices rise, the cash value of 20% of the good increases. Therefore, the govt. receives more tax revenue -> they can now spend this on funding + improving standards of living or to pay off debt.
• A negative of the impact of inflation on the govt. is that the govt. has to increase spending. This has to pay for the pay rises awarded to 5 million public sector workers. As the govt. have increased spending, some sectors may receive less funding and this could lower general standards of living, over a long time period.
• In judgement, the impact of inflation on the govt. will depend upon how long inflation remains high for.