2.1.2 - inflation

• Inflation is the general increase of prices in the economy which erodes the purchasing power of money.
• Deflation is the fall of prices and indicates a slowdown in the rate of growth of output in the economy
• Disinflation is a reduction in the rate of inflation i.e. prices are still rising but they are not rising by as much.
• consumer price index is the official measure used to calculate the rate of inflation, using a weighted basket of goods
• Limitations of CPI:

  • Substitution Bias - CPI assumes constant consumption patterns, whereas consumers often adjust their purchases in response to changing prices. This can lead to an overestimation of inflation.
  • Quality Changes - CPI may not adequately account for quality improvements in goods and services over time. This can result in an overestimation of price increases.
  • It does not include the price of housing and so, since this has tended to rise more than the price of other goods, the data may be lower than it should be.
• Demand-pull inflation occurs when aggregate demand exceeds aggregate supply, leading to upward pressure on prices.
• Cost-push inflation arises when production costs increase, causing firms to raise prices to maintain profitability.
• The formula for CPI inflation is: CPI Inflation Rate = [(Current CPI - Previous CPI) / Previous CPI] × 100.
• Retail Prices Index (RPI)

  • RPI is another measure of inflation in the UK that includes a broader range of expenditures than CPI.
  • It is used for various purposes, including index-linked bonds and some pension calculations.
• Effects of Inflation on Economic Agents

  1. Consumers

  • Inflation erodes the purchasing power of money, reducing the real value of savings.
  • Fixed-income earners may experience reduced real incomes.
  • People on fixed pensions may find it more challenging to maintain their standard of living.
• Effects of Inflation on Economic Agents

  1. Firms

  • Firms may face rising production costs, reducing profit margins.
  • They may adjust prices upward to maintain profitability.
• Effects of Inflation on Economic Agents

  
  

  1. Government

  • Inflation can increase the cost of servicing government debt, diverting resources from other public spending priorities.
  • Tax brackets may not be adjusted for inflation, resulting in "bracket creep" and higher tax burdens.
• Effects of Inflation on Economic Agents

  1. Workers

  • While workers may see nominal wage increases, their real wages may decline due to inflation.
  • Labor unions may negotiate for higher wages to keep pace with rising prices.