2.1.2 Inflation

• Inflation


  Sustained rise in the general price level over time, resulting in increased cost of living and decreased purchasing power of money
• Deflation

  Opposite of inflation, where the average price level in the economy falls and there is a negative inflation rate
• Disinflation


  Falling rate of inflation, where the average price level is still rising but to a slower extent, resulting in goods and services being relatively cheaper and increased purchasing power of money
• Inflation, disinflation, deflation


  • 4% increase in price level between 2014-2015 (inflation)
  • Change from 4% to 2% (disinflation)
  • Change in price level of -3% (deflation)
• Calculating inflation rate in the UK

  1. Using Consumer Prices Index (CPI)

  2. Measures household purchasing power with Family Expenditure Survey

  3. Creates weighted basket of goods

  4. Basket updated annually to account for changes in spending patterns
• In the UK, it is a government macroeconomic objective for inflation to be at 2% +/- 1% to maintain price stability
• Key points when answering an exam question on CPI

  • Survey used
  • Weighted basket of goods
  • Measures average price change of goods
  • Updated annually
• The basket of goods in CPI is only representative of the average household, so it is not accurate for households with different spending patterns
• CPI is slow to respond to new goods and services and it is hard to make historical comparisons due to changes in technology and product quality
• Retail Price Index (RPI)


  Alternative measure of inflation that includes housing costs such as mortgage interest and council tax, resulting in a higher value than CPI
• Causes of inflation


  • Demand pull
  • Cost push
  • Growth of money supply
• Demand pull inflation


  • From demand side of economy when aggregate demand is growing unsustainably, causing pressure on resources and producers increasing prices
  • Triggered by depreciation in exchange rate, fiscal stimulus, lower interest rates, high growth in export markets
• Cost push inflation


  • From supply side of economy when firms face rising costs, such as from more expensive raw materials, labour, expectations of inflation, indirect taxes, depreciation in exchange rate, monopolies
• Growth of money supply

  If money supply increases faster than real output, it can cause inflation, including hyperinflation from extreme increases
• Quantitative Easing by central banks can stimulate the economy but may also lead to higher inflation
• Effects of inflation on

  • Consumers
  • Firms
  • Government
  • Workers
• Effects of inflation on consumers

  • Those on low/fixed incomes hit hardest due to regressive effect on necessities
  • Value of debt repayments decreases
• Effects of inflation on firms

  • Borrowing and investing more attractive than saving profits
  • Higher costs of production from worker wage demands
  • Less price competitive globally
  • Reduced business confidence and investment
• Effects of inflation on government

  • Need to increase state pension and welfare payments
• Effects of inflation on workers

  • Real incomes fall, less disposable income
  • Potential for more redundancies as firms cut costs