Inflation (2)

What is inflation ?

• Inflation is the sustained increase in the average price level of goods/services in an economy

  • The average price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • The UK has an inflation target of CPI at 2% per annum

    • Low inflation is better than no inflation, as it is a sign of economic growth

What is deflation ?

• Deflation occurs when there is a fall in the average price level of goods/services in an economy

  • Deflation only occurs when the percentage change in pricesfalls below zero %

What is disinflation ?

• Disinflation occurs when the average price level is still rising, but at a lower rate than before

  • These figures demonstrate disinflation:  Y1 = 5% Y2 = 4% Y3 = 2%

    • Inflation is increasing but at a decreasing rate

Calculating inflation using the Consumer Price Index (CPI)

• Inflation is the sustained increase in the average price level of goods/services in an economy

• The inflation rate is the change in average price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2, then the inflation rate is 7%

What two inflation indices does the UK use ?

• The consumer price index (CPI)and the retail price index (RPI)

• Each is calculated slightly differently

The Consumer Price Index (CPI)

• A 'household basket' of 700 goods/services that an average familywould purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods/services exit the basket and new ones are added

• Goods/services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket

• Each month, prices for these goods/services are gathered from 150 locations across the UK

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

• CPI = Cost of basket in year x / Cost of basket in base year → x100

• The percentage difference in CPI between the two years is the inflation rate for the period

Limitations of using the CPI

• The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket

  • Depending on what households buy, the level of inflation for each one can vary significantly

  • As an average, it also ignores regional differences in inflation, e.g. London inflation may be much higher than Harrogate inflation

• The CPI is one of several methods used by countries in determining inflation; another is the retail price index (RPI)

  • This can make comparisons between countries less meaningful, as one may use the RPI and another the CPI

• The CPI does not capture the quality of the products in the basket

  • Product quality changes over time, so the comparison with different time periods is less useful

• The CPI only measures changes in consumption on an annual basis

  • Changes in consumption can occur more frequently and theindex is always behind these changes

• The CPI is prone to errors in data collection

  • It is based on a survey that goes to thousands of households each year, yet it is still a small sample

  • The respondents have no incentive to fill in the survey carefully and accurately

The Retail Prices Index (RPI)

• The retail price index (RPI) is calculated in exactly the same way as the CPI

  • Certain goods/services that are excluded from the CPI are included with the RPI

    • These include council tax, mortgage interest payments, house depreciation, and other house purchasing costssuch as estate agents fees

• Due to the extra inclusions, inflation measured using the RPI is usually higher than the CPI

  • This is mainly due to its sensitivity to interest rate changes,which affect mortgage interest

  • It's argued that the RPI is a more accurate indication of household inflation

The Causes of Inflation

• An increase in the average prices in an economy can be caused by demand-pull inflation, cost-push inflation, an increase in the money supply, and an increase in wages

Demand - pull inflation

• Demand-pull inflation is caused by excess demand in the economy

• Aggregate demand (AD) is the sum of all expenditure in the economy

  • AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

• Short-run aggregate supply (SRAS) is the total supply provided in the economy at a given average price level

A diagram that shows how an increase in aggregate demand raises the average price level in an economy - Diagram Analysis

• If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD₁ → AD₂

• At the original price (AP₁), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods and services are bid up from AP₁ → AP₂

• Demand pull inflation has occurred

Cost - push Inflation

• Cost push inflation is caused by increases in the costs of production in an economy

A diagram that shows how an increase in the costs of production raises the average price level in an economy - Diagram Analysis

• If any of the costs of production increase (wages, raw materials, etc.), there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂

• At the original price (AP₁), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods/services are bid up from AP₁→AP₂

• Cost-push inflation has occurred

Changes to the money supply

• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers

  • This will result in an increase in consumption and investment

  • It is likely to lead to a form of demand-pull inflation

• The Central Bank can also increase the money supply through quantitative easing - (Occurs when the Central Bank purchases securities (bonds) on the open market so as to increase the money supply)

  • This will result in increased liquidity and lower interest rates

  • It is likely to lead to a form of demand-pull inflation

Changes to Wages

• Increased aggregate demand in an economy causes demand pull inflation

• Workers now feel less well off as their wages no longer have the same purchasing power

• Workers may demand wage increases to compensate for the higher prices

• Those wage increases are now a form of cost-push inflation (increased costs of production) and drive prices even higher

• This economic phenomenon is called the wage-price spiral

The impact of inflation on different stakeholders

Firms	Consumers	Government	Workers
Uncertainty.Rapid price changes create uncertainty and delay investment Menu change costs. Price changes force firms to change their menu prices too and this can be expensive	Decrease in purchasing power Decrease in the real value of savings (as money will be worth less in real terms) Fall in real income for those on fixed incomes/pension	Inflation erodes international competitivenessof export industries Trade-offs involved in tackling inflation e.g reducing inflation may increase unemployment and/or reduce economic growth	Demand higher wages to compensate for reduced purchasing power If wage increases ≠ inflation, motivation and productivity may fall