2.1.2 Inflation

Define inflation

Inflation is defined as the sustained increase of the general price level, which erodes the purchasing power of money.

Define deflation.

Is the sustained decrease in the general price level and indicates a slowdown in the rate of growth of output in the economy.

Define disinflation.

Disinflation is a reduction in the rate of inflation i.e. prices are still rising but they are not rising by as much.

How do you create index numbers.

(new figure/base figure) x100

Nominal figures must be changed into real figures to make comparisons. This is done by choosing one year for the base year and adjusting all other figures into equivalent figures.

Define the consumer price index.

Official measure used to calculate the rate of inflation, using a weighted basket of goods.

What are the stages of calculated the consumer price index?

• Living costs and food survey

• Price survey

• Weighted average

Explain all 3 stages of calculated the CPI.

The Office for National Statistics (ONS) collects prices on 710 goods and services from 20,000 shops in 141 locations and online sites and the prices are updated every month, with collectors visiting the same retailers to monitor identical goods. New items are added to the list every year, such as microwaveable rice and nail varnish , whilst others are taken away, including organic carrots.

• All these prices are combined using information on the average household spending pattern to produce an overall price index. The average household spending is worked out through the Living Costs and Food Survey, where around 5,500 families keep diaries of what they spend over a fortnight.

• It takes into account how much is spent on each item so they are weighted i.e. we spend more on petrol than on postage stamps so an increase in petrol will have a bigger impact on the overall rate of inflation. This basket of goods is given a weight based on how important it is in the overall economy

What are the 3 limitations of the CPI?

• Not representative

• Excludes price of housing

• Difficult to make comparisons

Explain the 3 limitations of CPI.

It is impossible for the figure to take into account every single good that is sold in the country and so therefore the CPI is not totally representative . Similarly, different households spend different amounts on each good and so therefore the CPI only measures an average rate of inflation, and is not totally representative.

• Moreover, 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.

• Since the figure is more recent than RPI, it is difficult to make comparisons with historical data. It was only used since 1996 with estimates going back to 1988 which means that levels of inflation using CPI can only be accurately compared back to then.

Why do some people argue that all inflation indices overestimate inflation?

Some people argue that all inflation indices overestimate inflation because they don’t take into account the fact that goods and services have improved in quality, and so will obviously be more expensive. For example, a car in the 1950s would be far less comfortable and reliable than today’s. It has no way of indicating the change of goods that is bought.

Define the retail price index.

An old measure of inflation which has lost its national statistic status

What are the 3 differences between the RPI and CPI?

RPI includes housing costs such as mortgage and interest payments and council tax, whereas CPI does not.

• CPI takes into account the fact that when prices rise people will switch to product that has gone up by less. Therefore, the CPI is generally lower than the RPI.

• RPI excludes the top 4% of income earners and low income pensioners as they are not ‘average’ households whilst CPI covers all households and all incomes.

What are the 2 causes of inflation?

• Demand pull

• Cost-push

Explain demand pull inflation.

Prices in a market are determined by demand and supply and a shift in either will cause price to change. Inflation can therefore be caused by an increase in aggregate demand (AD), total demand for goods and services in the economy.

• If any factor which increases AD was to increase (2.2), then inflation would increase

Explain cost push inflation.

Whilst an increase in aggregate demand can push prices up, a decrease in aggregate supply may also push prices up.

• When businesses find their costs have risen, they will put up prices to maintain their profit margins. This can be caused by any factor which decreases AS (2.3)

How can the growth of the money supply lead to inflation?

• Another potential cause of inflation is there being too much money in the economy. If people have access to money they will want to spend it but if there is no increase in the amount of goods and services supplied, then prices will have to rise.

• The government can also increase the amount of money that they print and decisions to increase government borrowing can also increase the money supply.

Who does inflation impact?

• Consumers

• Firms

• Governments

• Workers

What are the 3 effects of inflation on the consumer?

• If peoples incomes do not rise with inflation then they will have less to spend, which could cause a fall in living standards

• Those who are in debt will be able to pay it off at a price which is cheaper value, but those who are owned money lose because the money they get back is of cheaper value. COnsumers who have saved their money will lose out as their money is worth less.

• Inflation has psychological effects on consumers: because prices are rising, they may feel well less-off, even if their income is rising in line with inflation, and so this may cause them to decrease their spending

What are the 4 impacts of inflation on firms?

• Britain will become less competitive if inflation is higher in Britain than in other countries, making their goods more expensive and difficult to export.

• Deflation isnt good as it encourages people to postpone their purchases as they wait for prices to fall further.

• People will be more likely to save as the value of their money will rise in the future and they will be prevented from borrowing as deflation means the real value of debt increases. This can lead to a fall in demand which can lead to a long term reluctance to invest

• In general, inflation/deflation is difficult to predict and so this means that firms cannot predict for the future.

What is the impact of inflation on governments?

If the government fails to change excise taxes (taxes at a set amount e.g. £1) in line with inflation then real government revenue will fall.

• However, if they fail to change personal income tax allowances (the amount a worker can earn tax free) then real government income will increase and taxpayers will have less money.

What is the impact of inflation on workers?

• If workers do not receive yearly pay rises of the rate of inflation, they will be worse off and their living standard will decrease. Those in weaker unions tend to be most affected as they are unable to win wage rises in line with inflation.

• Deflation could cause some staff to lose their jobs as there is a lack of demand meaning firms see a fall in profit and have to decrease staff to cut costs.

What is indexation?

Some of these costs can be reduced if inflation is anticipated, which will allow groups to plan for the future. This can be done through indexation, so wages or taxes are increased in line with inflation. An example of this is workers negotiating with employers for wage rises in line with the predicted CPI or RPI.

• However, indexation may in itself further inflation because wage increases will reflect past increases. Therefore, if inflation has been at 10% previously but the government wants to reduce it to 2%, this will be difficult if workers are still getting a 10% pay rise due to indexation agreements