2.1.2 Inflation

What is inflation?

A sustained increase in the general price level over time, causing the value of money to fall.

What is deflation?

A sustained decrease in the general price level over time.

What is disinflation?

A fall in the rate of inflation, meaning prices are still rising but at a slower rate.

What is the difference between inflation and disinflation?

Inflation means prices are rising, while disinflation means prices are still rising but more slowly.

What happens to purchasing power during inflation?

Purchasing power falls because money buys fewer goods and services.

What is the CPI?

The Consumer Prices Index is the main measure of inflation in the UK.

What does CPI measure?

The average change over time in the prices paid by consumers for a basket of goods and services.

What is the “basket of goods and services”?

A representative sample of products purchased by the average household.

Why does the basket of goods change over time?

To reflect changing consumer spending habits and new products.

Who collects CPI data in the UK?

The Office for National Statistics (ONS).

How is CPI calculated?

Price data is collected for a basket of goods and services, weighted according to importance in household spending, and compared over time.

What are weights in CPI?

Numerical values showing the importance of each item in consumer spending.

Why are some goods weighted more heavily in CPI?

Because consumers spend a larger proportion of their income on them.

How is the inflation rate calculated using CPI?

Percentage change in the CPI from one year to the next.

What is the formula for calculating inflation?

((New CPI − Old CPI) ÷ Old CPI) × 100.

If CPI rises from 120 to 126, what is the inflation rate?

5%.

Why is CPI considered a weighted index?

Because different items have different importance in household expenditure.

What type of inflation measure is CPI?

An index number measure.

Why is CPI useful?

It helps the government and Bank of England monitor price stability and make economic policy decisions.

What is the UK government’s inflation target?

2% CPI inflation.

Who is responsible for meeting the inflation target?

The Bank of England through monetary policy.

Why might CPI underestimate inflation for some households?

Spending patterns vary between households.

Why is CPI limited as a measure of inflation?

It uses averages and may not reflect individual experiences.

How can changes in quality affect CPI accuracy?

Improved quality may increase prices without reducing value to consumers.

Why can new products create problems for CPI?

They may not be included immediately in the basket.

Why may CPI not reflect regional differences?

Prices and spending patterns vary across regions.

Why is housing a limitation in CPI?

CPI excludes some housing costs such as mortgage interest payments.

What is substitution bias in CPI?

Consumers may switch to cheaper alternatives when prices rise, but the basket may not fully reflect this immediately.

What is RPI?

The Retail Prices Index is another measure of inflation in the UK.

How does RPI differ from CPI?

RPI includes housing costs such as mortgage interest payments, while CPI does not.

Which measure of inflation is usually higher, CPI or RPI?

RPI is usually higher.

Why is RPI usually higher than CPI?

Due to different calculation methods and inclusion of housing costs.

Why is CPI preferred by the UK government?

It is internationally recognised and considered more accurate for comparisons.

What is demand-pull inflation?

Inflation caused by aggregate demand growing faster than aggregate supply.

What causes demand-pull inflation?

High consumer spending, increased investment, government spending, or rising exports.

How can low interest rates cause demand-pull inflation?

They encourage borrowing and spending, increasing aggregate demand.

What is the relationship between aggregate demand and demand-pull inflation?

Excessive aggregate demand pushes prices up.

At what stage of the economic cycle is demand-pull inflation most likely?

During periods of rapid economic growth.

What is cost-push inflation?

Inflation caused by rising costs of production.

What causes cost-push inflation?

Rising wages, raw material costs, energy prices, or taxes.

How can higher wages cause inflation?

Firms face higher costs and increase prices to maintain profits.

How can rising oil prices lead to inflation?

Transport and production costs increase across the economy.

What is imported inflation?

Inflation caused by rising prices of imported goods or a fall in the exchange rate.

How can a depreciation in the exchange rate cause inflation?

Imports become more expensive, increasing production and consumer costs.

What is the wage-price spiral?

A cycle where wages rise, causing firms to raise prices, leading workers to demand higher wages again.

How can indirect taxes cause cost-push inflation?

Firms pass increased taxes such as VAT onto consumers through higher prices.

What is monetary inflation?

Inflation caused by excessive growth of the money supply.

How can growth of the money supply lead to inflation?

More money in the economy increases demand for goods and services, pushing prices up.

What is the quantity theory of money?

The theory that if the money supply grows faster than output, inflation will occur.

What are the effects of inflation on consumers?

Reduced purchasing power and lower real incomes.

How does inflation affect savers?

The real value of savings falls if interest rates are lower than inflation.

How does inflation affect borrowers?

Borrowers may benefit because the real value of debt falls.

How can inflation create uncertainty for consumers?

Consumers may struggle to plan spending and saving.

What are menu costs?

Costs to firms of changing prices, catalogues, and menus during inflation.

What are shoe leather costs?

Costs associated with reducing cash holdings during inflation, such as more frequent bank visits.

How can inflation affect firms?

Increased uncertainty may reduce investment and competitiveness.

Why can inflation reduce international competitiveness?

UK exports become relatively more expensive compared to foreign goods.

How can inflation affect profits?

Rising costs may reduce profit margins if firms cannot increase prices.

How can inflation affect business planning?

Uncertainty makes forecasting costs and revenues more difficult.

How does inflation affect workers?

Real wages fall if wage increases are below inflation.

What is a real wage?

Wage adjusted for inflation.

How can inflation lead to industrial disputes?

Workers may demand higher wages to maintain living standards.

How can inflation affect employment?

High inflation may reduce competitiveness and lower demand for labour.

How does inflation affect the government?

It may increase tax revenues through fiscal drag but also increase government spending.

What is fiscal drag?

When inflation pushes people into higher tax brackets, increasing tax revenue.

How can inflation increase government spending?

The government may need to pay more for wages, pensions, and benefits.

How can inflation affect unemployment benefits and pensions?

Governments may increase them to maintain real incomes.

What is the impact of unexpected inflation?

It redistributes income and wealth unpredictably between savers, borrowers, workers, and firms.

Why is low and stable inflation generally preferred?

It encourages confidence, investment, and stable economic growth.

What problems can deflation cause?

Consumers may delay spending, firms may reduce production, unemployment may rise, and economic growth may slow.

Why can deflation increase the real burden of debt?

Debt values stay the same while incomes and prices fall.

What is hyperinflation?

Extremely rapid and out-of-control inflation.

Why is hyperinflation damaging?

It destroys confidence in money and severely disrupts the economy.

How might the government reduce demand-pull inflation?

By using contractionary fiscal or monetary policy.

How might interest rates reduce inflation?

Higher interest rates reduce borrowing and spending.

How can taxation reduce inflation?

Higher taxes reduce disposable income and aggregate demand.

How can the government reduce cost-push inflation?

Policies to improve productivity or reduce business costs.

What is stagflation?

A situation with high inflation and low or negative economic growth, often with high unemployment.