Inflation

What is inflation?

Inflation is a sustained increase in the average price level of an economy

What is the inflation rate?

The rate of inflation is measured by the annual percentage change in the level of prices as measured by the consumer price index

What are the causes of inflation?

• Cost-push Inflation: The cost of all factors of production is increasing EG.
  Raw materials, wages, energy, taxation. - resulting in price rises.

• Productivity doesn't match Output levels: workers want higher pay without producing more output - Firms are forced to increase prices

• Demand Push Inflation: There is too much demand for goods and services and insufficient output to match that demand IE. The economy cannot produce more since capacity is already fully utilised

• Inflationary expectations: prices rise because consumers and businesses lose confidence in price stability. Firms anticipate cost increases and increase prices accordingly

• Hyperinflation is the stage where confidence is completely lost and prices rise very rapidly

What are the effects of inflation on consumers?

• Money loses its value and people lose confidence in money as the value of savings is reduced

• Inflation can get out of control- price increases lead to higher wage demands as people try to maintain their living standards

• Consumers on fixed incomes (e.g. pensioners) lose out because their real incomes fall

What are the positive effects of inflation on business?

• Some inflation is good for businesses

• Industry-wide price rises enable revenues to grow

• Growing revenues + constant gross margin= higher gross profit

• Makes using debt as a source of finances cheaper in real terms

What are the business effects on inflation?

• If costs are rising due to inflation, a business may not be able to pass them on to customers (PED)

• Inflation can disrupt business planning and lead to lower investment

• Rising inflation is associated with higher interest rates- this reduces economic growth and can lead to a recession

How should you measure inflation?

• Consumer Prices Index ( CPI)

• UK Inflation Target is set by the Government: 2%

• Bank of England Monetary Policy Committee is charged with setting Interest rates with the aim of keeping inflation at the Government's target

• CPIH Consumer Prices Index including Owner Occupiers' Housing Costs

What are the impacts on business?

• If Inflation is low then Businesses find borrowing less expensive and loans become cheaper.

• If inflation is high then loans will become easier to repay as time progresses.
  Sales Revenue will be increasing due to Inflation induced price rises

• But higher prices may be difficult to achieve if demand is price-elastic

• High Inflation leads consumers to become more price-sensitive and switch to cheaper brands

• Employees seek to recoup lost income due to high inflation - and an increase in industrial disputes leading to lost economic output

• Suppliers also seek higher prices from their customers

• UK international competitiveness is affected if UK inflation is higher than elsewhere

What are the impacts on low inflation?

• Low inflation tends to lead to lower interest rates

• Low inflation provides price stability, and if it remains at a lower rate than other competing economies exporting firms become more competitive in overseas markets. Additionally, they become more competitive in their domestic markets against imports from abroad.

• Low inflation allows businesses to plan ahead longer term due to the more stable economic environment and the reduced requirement to react to short-term pressures. Eg. Constantly having to review pricing strategy.

• Low inflation squeezes out inefficient businesses from a market. They cannot continually increase prices to mask their poor productivity compared to their more efficient competitors

What is deflation?

A period marked by continually falling demand and a fall in prices

How does deflation affects a business?

• Consumers hold off purchasing goods and services because they expect prices to reduce further

• Investors stop investing because they anticipate diminishing returns

• Deflationary conditions present businesses with difficult pricing decisions: Consider the price elasticity of demand for a product and the competitive environment when evaluating whether price reductions are required.

• In addition, a firm's costs may not reduce as rapidly as market price levels

What is macroeconomics?

• The strategies that businesses pursue are influenced by the overall economic environment appertaining at a particular time

• It’s a branch of economics that focuses on the study of the economy as a whole. It deals with the behaviour, performance, and structure of an entire economy rather than individual markets or industries. Macroeconomists analyse factors such as overall economic output (GDP), inflation, interest rates, unemployment, national income, and government policies that impact these aspects. It aims to understand and address issues like economic growth, business cycles, monetary and fiscal policy, and the overall well-being of a nation's population.

• Governments aim to pursue macroeconomic policies which they believe will encourage and enhance economic growth.