3.4 - Price Stability

define price stability

when the general level of prices stays constant over time / grows at an acceptably low rate

define inflation

a sustained rise in the general price level over time

define rate of inflation

% rise in general level of prices over time

formula for rate of inflation

(change in price / old price) x 100

what does negative inflation mean

means on average, prices are falling, which is called deflation

define nominal value

value of something in money terms

define real value

takes into account effects of inflation

how is CPI calculated

a weighted average of prices of a large basket of everyday products is taken, depending on how much money households spend on each thing

two causes of inflation

too much demand (demand-pull)
rise in costs of production (cost-push)

define demand-pull inflation

arises when the aggregate demand in the economy rises and the aggregate supply of G/S cannot change to match the increase in demand, so the price level is pulled up

causes of demand-pull inflation (4)

• economic boom - workers have higher incomes, less unemployment, so consumer spending rises

• increased demand for exported goods - maybe because of quality of exported goods has improved, or trade deals have been made

• govt spending more money on economy, eg on infrastructure, increasing demand for G/S

• firms investing more, increasing demand for capital goods

when is demand-pull inflation more likely to happen

in an economy is near or at full capacity, eg near full employment. any demand increase cannot be met by a supply increase.

define cost-push inflation

arises when there are high costs of production and firms then raise their prices of G/S

causes of cost-push inflation (5)

• raw material prices rising - eg rising prices of oil, metal, wood, etc, due to scarcer supply, increasing prices of raw materials

• trade unions pushed for higher wages, increasing labour costs

• govt increased NMW rates, increasing labour costs for some businesses

• productivity has fallen - each worker produces less output, so higher labour costs per unit of output

• higher prices of international goods, due to inflation occurring in other countries

when is cost-push inflation more likely to occur (4)

• trade unions are stronger

• raw materials are experiencing shortages

• govt increases NMW significantly

• other countries experience high inflation

consequences of inflation to consumers (5)

• loss of consumer confidence - unsure what they can afford, lower purchasing power

• shoe leather costs - must shop around longer to find best prices; extra time and effort, opp cost

• falling real incomes - rate of inflation is higher than change in wage rates

• consumers who owe debt gain - real value of debt owed falls, so they don’t have to pay as much back

• income redistribution problems - lower-paid jobs / lower earners suffer due to lack of bargaining power for wage rates

consequences of inflation to producers (6)

• more flexibility - low inflation good as can increase wages very slightly to keep workers happy

• menu costs - firms spend time + money keep updating price lists

• labour market conflicts - falling real wages causes employees and trade unions to try protect incomes, leading to strikes and industrial action

• unemployment - UK G/S will become less price-competitive as prices rise, sell less output, so derived demand for labour falls

• producers lose as creditors - if banks are owed money, real value of debt falls, so they are paid less back

• producers lack business confidence - uncertainty due to price instability, less investment, lower demand, lower economic growth

consequences of inflation for savers (1)

real value of savings falls, (if inflation > interest) so less money saved overall

consequences of inflation for government (5)

• gains as debtor - real value of govt debt falls, so less must be repaid

• spends more on benefits, eg welfare benefits

• spends more as a major employer, demand for higher wages increases during inflation so may need to borrow more to increase wages

• receives more in tax revenue - higher VAT when prices rise, higher income tax if incomes also rise with inflation

• must use policies to combat inflation