INLATION

• Inflation

  A sustained increase in the general price level of a country over time (usually one year) / fall in the purchasing power of money
• The government sets the Bank of England a CPI inflation target of +2% (+/- 1%). From 1997 to 2021, this was generally achieved, with UK inflation averaging around 2% a year.

  
• Increase in demand, as the economy began to recover from the COVID-19 crisis, and shortages of many goods due to supply chain bottlenecks (constraints)


  Prices began to rise
• Hyperinflation


  Where inflation is rising at very high rates, maybe hundreds, thousands or even millions of per cent a year

  
• The "world record" inflation level was reached at the peak of the severe hyperinflation suffered in Zimbabwe in the first decade of this century. In mid-November 2008, it was estimated at 6.5 sextillion (that is 6.5 followed by 21 zeros) per cent.
• Deflation


  A fall in the general price level (i.e. the inflation rate falls below 0% and becomes negative) and means that goods are becoming cheaper to buy
• Disinflation, which is where the rate of inflation is lower than in the previous period, but still remains positive (e.g. UK inflation fell from 10.5% to 10.1% between December 2022 and January 2023).

  
• Deflation involves a negative rate of inflation (e.g. the UK year-on-year inflation rate in April 2015 was -0.1%).

  
• Deflation is traditionally associated with a recession
• Deflation might sound like a good thing, but it stops economic activity as people are constantly waiting for prices to fall further before purchasing goods.
• Stagflation

  Recession or a "stagnant" economy (with zero/negative economic growth) and inflation at the same time
• Price index


  The means of measuring the inflation rate – the speed at which prices of goods and services bought by households are going up or down (on average) in the economy over time (normally one year)

  
• Price indices (or indexes) are calculated using a typical basket of goods and services (think of a very large shopping basket containing all the goods and services bought by households).
• The price index records prices every month and estimates changes to the total cost of this basket of goods. The Office of National Statistics (ONS) publishes consumer price indexes every month.
• The basket of goods is regularly updated to reflect changes in what people are buying.
• 
  

  Takes a particular year as its "base" and looks at changes that take place around that base year (both after and before) in relation to the base value, which is always 100
• The main consumer price indexes used for private households in the UK


  • Consumer Prices Index (CPI)
  • Consumer Prices Index including Owner Occupiers' Housing Costs (CPIH)
  • Retail Prices Index (RPI)
• Differences between CPI and RPI

  • 1) RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not (though CPIH includes some of them).
  • 2) CPI takes into account that, when prices rise, some people will switch to lower-priced alternatives. E.g. they will swap a higher priced brand of biscuits (cookies) for a lower priced one. This results in a lower CPI reading than RPI in nearly all cases.
• Low-income households (including pensioners) usually have an inflation rate that is relatively higher than middle-class households, as they usually spend a greater proportion of their income on food (the price of which tends to rise in particular, at times of rising generalised inflation). By contrast, the highest income earners in society tend to have a lower than average inflation rate.
• Rural households (who live in the countryside) need to travel far greater distances/far more often by car, so a big rise in petrol prices, would push their inflation rate higher that of most urban households.
• Quality changes (often improvements) are not reflected in the CPI figures; changes to the CPI basket of goods are often slow to be introduced and so may not reflect current spending trends.
• Costs of inflation


  • Hyperinflation destroys the functions of money (medium of exchange, unit of account, store of value) and trust in the domestic currency and possibly its issuer (central bank or government).
  • Decline in the purchasing power of money, which can have negative effects on consumer/business confidence and reduce consumption and investment.
  • Economic instability, slower economic growth, and worsening international competitivity and resulting balance of payments deficits (lower net exports).
  • Lower living standards for people on fixed incomes or with limited savings/wealth, possibly leading to/increasing inequality and poverty.
  • Falling real wages may result in strikes and other political unrest.
  • Shoe-leather (time) and menu costs may also occur – though less in the digital age than in the past.

  
• Demand-pull inflation

  Original Keynesian view of demand-pull inflation, where excess aggregate demand (AD) leads to a rise in the price level (inflation) if the economy is at, or near, full employment

  
• Components of Aggregate Demand

  • C (Consumption)
  • I (Investment)
  • G (Government spending)
  • X (Exports) - M (Imports)

  
• Causes of excess demand

  • Rapid increases in consumption (consumer boom)
  • Increased spending on capital goods
  • Large increases in Government Spending
  • Large increase in exports (an export boom)

  
• Cost-push (or "supply shock") inflation

  Inflation caused by rising costs of production, with the main sources being wages, imported goods, profits and taxes

  
• Wage-price spiral

  An initial supply shock causes a rise in the price level, leading to the labour force demanding a wage rise to match the rate of inflation, which is then passed on to consumers in the form of higher prices, inspiring another round of wage demands

  
• Monetarist explanation of inflation

  Inflation is caused by an excessive growth of the money supply, where excess demand is only made possible by increases in the money supply

  
• Quantity Theory of Money (Fisher formula)

  M (Money supply) x V (Velocity of circulation) = P (Price level) x T (Number of transactions over a period of time)
• If the money supply increases

  There will be changes in transactions and velocity, but Monetarists believe the rate of change between them is a constant ratio, resulting in a close link between money supply and the price level

  
• Contractionary monetary policy

  • The main method of counter-inflation policy used in the UK today, with the major instrument being interest rates set by the Bank of England's Monetary Policy Committee
  • Other measures include reserve ratio, credit controls, and quantitative tightening (QT)

  
• Contractionary fiscal policy

  • The government tries to reduce aggregate demand by lowering government spending on public and merit goods or welfare payments, and possibly raising direct taxes
• Supply-side policies

  • Designed to increase total supply of goods and services in the economy, through improved productivity, competition, and innovation in markets, shifting the LRAS curve to the right
• The Bank of England's target is to keep inflation at 2%, but with inflation remaining much higher, the Bank has increased interest rates to 5.25%

  
• Increasing interest rates can harm the economy by leading to higher mortgage repayments for homeowners, less borrowing and investment by businesses, and job cuts