Contemporary Economics - Inflation

For exam on the 22nd Jan

Inflation definition

An increase in the general price level

Inflation formula

Inflation evaluation

• If inflation > 0 prices will continue to rise

Main measures of inflation in the UK

• Consumer Price Index (CPI)

• Retail Price Index (RPI)

• Consumer Price Index (CPIH)~ including owner occupied housing costs

Problems with measures of inflation

• Not an indicator of price level

• Substitution bias - When price of smt increases ppl sub away but inflation measure doesnt change whats in the basket so quickly

• Inequality - Low income families may be especially affected

  • The affects of inflation are not clear from a singular number

Why can it not be argued that inflation has a limited effect?

Distorted economic signals - If prices rise this may hide the changes in relative prices that should provide signals to producers and consumers

How can economic individuals use inflation to influence their economic decisions?

• Savers to borrowers - they use it to distinguish between nominal and real IR

  • SAVERS: if nominal IR r_t = 5% but prices rise over the year by 𝜋_t = 5% then by the end of the year no interest is gained

  • Inflation erodes the real value of savings

  • BORROWERS: if you borrow at nominal rate r_t = 10% but prices rise over the year at rate 𝜋_t = 20% then by the end of the year the real value of the money you owe wouldve fallen

  • Inflation lowers debt in real terms

Main types of inflation

• Cost push inflation

• Demand pull inflation

What is cost push inflation?

inflation caused by higher production costs

What does cost push inflation do?

Forces businesses to raise prices to cover those higher costs

Causes of cost push inflation?

• Disrupted supply chains

• Shocks to input costs

• Weakening of the exchange rate

Example of cost push inflation

Ukraine war - Caused an increase in energy costs

• European wholesale increased by 237%

What is demand pull inflation?

inflation caused by high demand

What de=oes demand pull inflation do?

Increase pries because goods and services are in short supply

Causes of demand pull inflation

• High levels of money supply

• Interest rates

Example of demand pull inflation

QE during financial crisis

• Used to increase money supply in the economy by buying bonds to lower IR and encourage lending and spending

Solutions to inflation

• BoE set an inflation target of 2%

  • set to be achieved via monetary policy (manipulating IR)