2.1.2 Inflation

What is inflation?

Inflation= general rise in prices of goods and services that erodes the purchasing power of money across an economy

What is deflation?

Deflation= general price level for goods and services is falling and indicates slowdown in growth rate of output in economy

• it is negative (e.g. -3%)

What is disinflation?

Disinflation= fall in (annual) rate of inflation

• still prices rising but not rising as much

  • positive (e.g from 4% to 1%)

What is reflation?

Reflation= rise in GDP which occurs following a recession

What is stagflation?

Stagflation= inflation is rising or is very high at a time when an economy is in recession + rising unemployment

What is deflationary policies?

Deflationary policies= policies pursued by governments, designed to reduce economic growth rate

What are the two ways of measuring inflation?

Two ways of measuring inflation=

• Consumer Price Index (CPI)

• Retail Price Index (RPI)

How does Consumer Price Index (CPI) work?

Consumer Price Index works by=

• Office for National Statisitics (ONS) collects prices on 710 goods & services from 20,000 shops in 141 locations incl online sites (which are updated every month)

• all these prices are combined using information on the average household spending pattern to produce an overall price index - through the Living Costs and Food Survey ( few thousand households are asked to record their expenditure)

• prices are weighted →

  • if we spend more on petrol than on postage stamps so an increase in petrol will have a bigger impact on overall rate of inflation

What are the limitations of CPI?

Limitations of CPI=

• CPI is not totally representative as it is impossible for the figure to take into account every single good that is sold in the country; different households spend different amounts on each good so CPI only measures an avg. rate of inflation

• CPI does not influde price of housing (tended to rise more than the price of other goods) ; data could be lower than it should be

• CPI is a more recent measure- difficult to make comparisons with historical data- only used since 1996

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

Some people argue that all inflation indices overestimate inflation as they do not take into account that goods & services have improved in quality, so will be more expensive

• for e.g. a car in the 1950s would be far less comfortable and reliable than today’s

What are the basket of goods?

Basket of goods= 600/700 items (disappear and then swapped→ people’s spending habits change and become less popular vice versa)

• DVD rental → video streaming subscription

How does the Retail Price Index (RPI) work and who uses it?

Retail Price Index (RPI) works by=

• RPI (traditional measure of price level) measures average price of ‘basket of goods’ bought by average household – measures average consumer goods

• T.U & firms may use the RPI in wage agreements

• Property companies use RPI for calculating increases in leases/rents on property

• also calculated for different types of goods and services

  • e.g. food

  • one/two-pensioner households

What does the Retail Price Index (RPI) include/ exclude?

Retail Price Index (RPI) includes=

• housing costs, such as mortgage, interest payments, council tax (CPI doesn’t include)

• the fact that when prices rices, people will switch to the product that has risen less (CPI lower than RPI)

• excludes top 4% of income earners + low income pensioners, as they’re not average households

What are the 3 causes of inflation?

3 causes of inflation=

• demand-pull inflation

• cost-push inflation

• growth of money supply

What is demand-pull inflation?

Demand- pull inflation= increase in aggregate demand/ excess in demand in the economy→ leading to upward pressure on the general price level (price level will rise)

• too much demand, the price level will rise

• as AD rises (shifts to the right), greater pressure on existing factors of production (land, labour, capital and enterprise) to produce more output→ these factors of production become scarcer 

• increased demand for scarce resources→ increase in their prices

• these increased costs of factors of production → higher production costs for firms → firms will pass these higher production costs to consumers in the form of higher prices for goods and services 

What is the diagram for demand-pull inflation?

How can increase in AD happen?

Increase in AD can happen by=

• Lower interest rates C,I,(X-M)

  • borrowing cheaper for consumers (to borrow and spend on g+s) and businesses (increased spending on investment)

• Lower income tax C,I

  • increases consumers’ disposable income

• Lower corporation tax C,I

  • increases firms’ retained profits, more funds for investment

• Higher consumer and business confidence C,I

  • consumers are more likely to spend, businesses are more llikely to invest

• Higher government spending G

• Weaker exchange rates (X-M)

  • makes exports cheaper → increasing demand for exports → increase in export revenue

What is cost-push inflation?

Cost-push inflation= increase in the costs of production for firms// rising costs→ SRAS curve shifts to the left 

• firms increase the prices of their goods to protect their profit margins(how much money you keep after paying for the stuff you needed to make the good/service) → pass on these “higher costs” to consumers by increasing prices

How can a decrease in AS happen? (SRAS curve shifts to the left)

Decrease in AS can happen by=

• Increase in the prices of raw materials- like oil

• Increase in wages (labour then becomes more expensive for firms)

• Increase in taxes, e.g. VAT

• Increase in price of imported raw materials due to a weaker exchange rate 

What is the diagram for cost-push inflation?

How can growth of money supply be a potential cause of inflation?

Growth of money supply can be a potential cause of inflation= there being too much money in the economy

• people will spend their money, but if there is no increase in the amount of goods and services, prices have to rise

• Government can also increase the amount of money that they print and increase government borrowing → increase money supply

• Banks have the bank multiplier: when a bank receives a deposit, it is required to hold a fraction of that deposit and can lend out the rest; this loan becomes a new deposit→ cycle

Where does the idea that the growth of money supply leads to inflation come from?

This idea comes from the Quantity Theory of Money=

fisher equation= MV=PT

• where M is the money supply, V is the speed of money circulating in the economy, P is the price level, T is the number of transactions

  • increase in the money supply will lead to an increase in price level

What are the 6 costs of high inflation?

6 costs of high inflation=

1. Lower purchasing power

2. Erosion of savings → shoe leather costs

3. Lower export competitiveness

4. Wage/consumer price spirals→ menu costs

5. Fiscal drag

6. Inflationary noise

Why is lower purchasing power a cost of high inflation?

Lower purchasing power is a cost of high inflation=

• if wages and incomes do not rise in line with inflation, households and workers experience a decline in their real income→ reduces ability to purchase essential goods and services and decrease in living standards

• low-income individuals can be in poverty

Why is erosion of savings a cost of high inflation?

Erosion of savings→ shoe leather costs, a cost of high inflation=

• interest earned on savings may not keep up with rate of price increases→ real value of savings decreases

• individuals who rely on their savings, e.g. unemployed, pensioners, face a potential decline in their living standards

  • shoe leather costs→ when individuals spend time and effort searching for better interest rates on their savings due to high inflation

    • can discourage people from saving

Why is lower export competitiveness a cost of high inflation?

Lower export competitiveness is a cost of inflation= if a country’s inflation rate is higher than its trading partners, its exports will become expensive

• so lead to a decrease in demand for the exports, decrease in revenue

Why is wage/ consumer price spirals→ menu costs, a cost of high inflation?

Wage/ consumer price spirals is a cost of high inflation=

• workers anticipate high inflation, demand higher wages to maintain purchasing power so firms pass labor costs through higher prices (to protect their profits)

• consumers anticipate high inflation, buy goods and services while prices are still relatively lower→ increase demand-pull inflation

  • menu costs→ businesses change their prices frequently: e.g. reprinting menus, upd

Why is fiscal drag a cost of high inflation?

Fiscal drag is a cost of high inflation= people’s income/wages increases in nominal terms → increasing tax revenue for the government, yet leads to a reduction in disposable income and living standards for individuals

Why is inflationary noise a cost of high inflation?

Inflationary noise is a cost of high inflation= uncertainty caused by volatile (all over the place) inflation rates

• it becomes difficult for consumers and producers to see whether price changes reflect market shortages/ surpluses or not

• so consumers may postpone their purchases or firms may delay their long-term investment plans

What are the benefits of (low and stable) inflation?

Benefits of (low and stable) inflation=

1. workers with higher wages

2. consumption is natural

3. firms encouraged to increase output

4. can keep unemployment low in a recession

5. reduces real value of debt

6. improvement of government finances

Why are workers with higher wages a benefit of (low and stable) inflation?

Workers with higher wages is a benefit of (low and stable) inflation=

• workers can negotiate higher nominal wages, so even if an inflation-equalling pay rise→ boosts morale and may improve productivity

Why is natural consumption a benefit of (low and stable) inflation?

Natural consumption is a benefit of (low and stable) inflation= consumers make purchases when needed so supports steady economic growth

Why are firms encouraged to increase output a benefit of (low and stable) inflation?

Firms encouraged to increase output is a benefit of (low and stable) inflation=

firms can raise their prices gradually so it encourages revenue growth and long-term planning

Why is ‘can keep unemployment low in a recession’ a benefit of (low and stable) inflation?

Can keep unemployment low in a recession is a benefit of (low and stable) inflation=

• In a recession it is normal for firms to sack their workers, since their revenue is falling→ in order to keep their profit margins

• BUT firms don’t want to do that

• if inflation was 5%, firms can raise their prices by 5% and even give their workers a 1% pay rise→ profitable

Why is reduces real value of debt a benefit of (low and stable) inflation?

Reduces real value of debt a benefit of (low and stable) inflation=

• fixed-value debts become easier to service

• as wages, profits and revenues rise with inflation

  • applies to mortgage debt, credit card debt etc

Why is improvement in government finances a benefit of (low and stable) inflation?

Improvement in government finances is a benefit of (low and stable) inflation=

governments get a fiscal windfall (inflation increases government revenue through multiple channels)

• fiscal drag → workeres who are earning more nominal income get pushed into higher tax brackets

• VAT revenue increases: so as prices rice, the government collects more VAT

• Rising fuel prices create more tax revenue

What is economic boom + money and credit boom an example of?

Economic boom + money and credit boom are an example of demand-pull inflation

What are

• higher wage costs

• higher indirect taxes

• increased energy bills

• falling exchange rate

examples of?

Higher wage costs, higher indirect taxes, increased energy bills and falling exchange rate are examples of cost-push inflation

What did Milton Friedman quote about the effect of money supply on inflation?

Milton Friedman= “too much money chasing too few goods”