booklet three -inflation

• what is an index number?

  a device for comparing the value of a variable in one period or location with a base observation
• the current value of the index number can be calculated as the current value divided by the base value multiplied by 100

  current/ base x 100 = index
• what is the consumer price index?

  "A MEASURE OF THE GENERAL LEVEL OF PRICES IN THE UK. IT IS THE RATE OF CHANGE THAT HELPS THE GOVERNMENTS INFLATION TARGET"

  
  

  it is a measure used by the government in setting its inflation target.

  it is based on PRICES OF A BUNDLE OF GOODS AND SERVICES MEASURED AT DIFFERENT POINTS IN TIME

  it is calculated using the household consumption expenditure survey
• how is the CPI calculated?

  the ONS decided on the 700+ goods and services the typical household buys.

  the ONS then collects prices for these products from shops

  some goods and services are more important than others to households and are given different weightings to reflect this based on the proportion of their income households spend on it

  the index is then calculated and prices are then compared year on year
• how does the CPI help households to understand the rate of inflation?

  helps them understand how their disposable income levels are affected and helps them plan their spending

  helps them ask for a pay increase that increases their real income

  helps them check their savings are increasing in real terms
• how does the CPI help businesses to understand the rate of inflation?

  allows them to be able to monitor their cost of production

  helps them predict consumer spending trends

  helps to assess what pay increase they should give to their workers

  helps them check if savings and investments are increasing in real terms

  helps them assess if it is affecting their competitiveness in exports
• how does the CPI help he government?

  helps them be able to monitor costs

  helps them to choose the right combination of economics policies

  helps them decided how much to increase welfare benefits or min wage

  helps them decide if they need to increase/ decease tax
• what is inflation

  the rate of increase in the average price level in an economy
• what are the alternative measurements of inflation?

  the retail price index
• what are the similarities of the CPI and RPI?

  both set out to measure the overall price level at different points in time

  based on calculating the overall cost of a "basket of goods"

  both indices show how the general level of prices change in relation to a BASE year
• what are the negatives of the CPI and RPI?

  both use fixed weights to calculate the overall index - the weights do not pick up the substitution effect so the cost of living is higher than it truly is
• what are the differences between the RPI and CPI?

  there are differences in what the "basket of goods" includes

  CPI tends to underestimate inflation

  there are difference in the types of households whose expenditure patterns are considered - RPI excludes the highest earning households and pensioners
• what are the limitations of the CPI as a measure of inflation?

  1. the cpi is not fully representative

  shown by:

  it will be inaccurate for the non typical household (those who dont drive)

  single people have different spending patterns to those with children

  the weightings may not be accurate as we all have our own weightings depending on our needs

  2. housing costs can vary ( the CPIH tries to fix this)

  3. changing quality of goods and services

  4. the cpi is sometimes slow to respond to the mergence of new products and services
• what are the three main causes of inflation?

  1. cost push inflation
  2. demand pull inflation
  3. an increase in money supply
• what is cost push inflation?

  increase in the cost of production

  means that costs 'push up' prices

  reduces the ability of firms to supply

  decrease in AD
• what is an inflationary spiral?

  when prices are high due to inflation, workers might ask for an increase in wages, leading to firms having to increase their prices further to compensate for the increase in cost of production
• what is demand-pull inflation?

  inflation caused by an increase In spending in the economy.

  this increase in AD pulls up prices

  excessive demand in the economy causes prices to rise as too much demand is chasing too few goods
• what is money supply inflation?

  an increase in money supply may cause inflation because the value of money may decrease and businesses can increase prices because everyone has money. purchasing power decreases the 'real' spending power of money has decreased.
• how does the value of savings fall due to inflation?

  during the time that savings are in a bank account, the rate of inflation could increase. prices of many goods and services will increase.

  if the rate of inflation is higher than rate of interest on savings
• what is the real rate of interest during times of inflation?

  the real rate of interest= the nominal rate - the interest rate
• What is one consequence of inflation in the UK?

  Firms become uncompetitive due to higher prices
• How does inflation create uncertainty for business investment?

  Businesses become cautious, leading to reduced investment
• What is the relationship between inflation and unemployment?

  Inflation can lead to job losses due to decreased investment
• How does inflation affect borrowers and savers differently?

  Borrowers benefit while savers lose purchasing power
• What happens to purchasing power for those on fixed incomes during inflation?

  Purchasing power falls as prices increase
• What are inflationary expectations and their impact on wages?

  They can cause wage claims to match CPI rises
• What are menu costs in the context of inflation?

  Costs incurred by firms to change prices
• What is inflationary noise?

  It distorts market signals affecting decision-making
• How does fiscal drag relate to inflation and income tax brackets?

  Higher incomes from inflation can push workers into higher tax brackets
• What is hyperinflation?

  Extreme and rapid inflation rates
• what are the effects of increasing inflation on consumer

  increase cost of living

  reduced real income

  lower standards of living

  consumers on fixed income most affected

  reduced real value of savings
• what are the effects of increasing inflation on firms

  increased cost of production leads to them increasing prices

  reduced international competitiveness

  reduced profit

  less certainty in investment

  menu costs

  workers pushing for higher wages
• what are the effects of increasing inflation on the government?

  value of tax revenue is reduced

  public spending costs on NHS

  possible increased borrowing

  value of exports decrease
• what are the effects of increasing inflation on the workers?

  workers in low paid jobs suffer the most

  firms may cut jobs to reduce costs

  less confidence affects AD
• what does the impact of inflation depend upon?

  timescale

  the extent to which the central bank and government are successful at using policies

  wether an inflationary spiral occurs - ceterius paribus

  how much the uncertainty affects consumption and investment
• why isn't the inflation target for the uk zero?

  a low rate of inflation is a good sign as it indicates rising demand. this indicates economic growth.

  wages and prices tend to be sticky downwards as firms are reluctant to cut prices and wages

  inflation that is low and stable act as an effective signal in the economy and can encourage consumers to spend
• what is a consequence of deflation?

  consumers may put off buying more items as they believe next month the prices will be lower and therefore they do not spend and the economy can become stagnant

  this is because demand for products decreases an therefore businesses may cut prices meaning they make less profit and may lay off workers
• what are the consequences of deflation?

  1. price cuts result in business meltdowns and therefore bankruptcies
  2. consumers hold back on spending meaning there's a decrease in AD and a contraction in the economy
  3. consumer confidence decreases and savings increase
  4. the real cost of borrowing increases
  5. lower profit margins for firms
  6. increased unemployment
  7. uncertainty and less foreign investment
• what are the advantages of deflation?

  prices of goods and services are going down. meaning more spending power for workers

  to control it the central bank may reduce interests rates and this helps stimulate AD and helps those who save

  can help correct prices that are too high
• what is stagflation?

  a situation where both unemployment and inflation are high