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What is the meaning of inflation?
Inflation is a sustained increase in the general price level.
This leads to a fall in the real purchasing power of money i.e a rise in the cost of living.
How is the rate of inflation measured?
By the annual percentage change in consumer prices.
What has the UK government set an inflation target to?
Set it to 2% using the Consumer Price Index(CPI).
What is the job of the Bank of England with inflation?
To set monetary policy base interest rates so that inflationary pressures are controlled, and the inflation target is reached over a 2 year forecasting time period.
What is deflation?
Deflation is when there is a fall in the general price level i.e ‘negative inflation’.
The annual percentage change in consumer prices is negative.
What is disinflation?
A slowdown in the rate of increase of prices.
Prices are still rising but at a slower rate, for example a drop in the annual inflation rate from 6% to 2%.
What is the Consumer Price Index?
The main measure of inflation used in the UK(although there are numerous other measures);increasing the CPIH(Consumer Price Index including owner-occupied housing)is used.
How is the measurement of CPI carried out?
A base year for prices is selected, and a family expenditure survey is carried out-the survey covers many thousands of UK households.The survey tracks what people are buying.
What else is used to measure CPI?
A representative basket of over 600 goods and services is used,and weights are attached to each item-based on these items’ importance in people’s expenditure.
Weights are then multiplied by price changes.
The weighted price changes are then totalled to calculate the inflation rate.
Formula for CPI:
Sum of prices indices x weights/divided by sum of weights
Some limitations of CPI as a measure of inflation:
The CPI is not fully representative-it will be inaccurate for the ‘non-typical’ household,e.g 14% of the CPI index is devoted to motoring costs-inapplicable for non-car owners.
Spending patterns:e.g single person household have different spending patterns from households that have children.
Doesn’t account for regional differences in the cost of living.
Overall what does this tell us about the CPI?
Only a sample of prices in the economy.
CPI doesn’t include housing costs-which has a large effect on households.
What is Hyper-inflation?
A period of high rates of inflation,usually leading to a loss of confidence in an economy’s currency.
Determine the inflation rate:
The annual rate of change of the average price of goods and services.
Determining purchasing power:
The buying power of a unit of currency; it is inversely related to the rate of inflation.
Determine Unit labour costs:
Reflected total labour costs, including social security and employers’ pension contributions ,and including the costs of self-employed labour ,incurred in the production of a unit of economic output.
Domestic causes of inflation:
Inflationary pressures within the domestic economy come-for example-from rising wage costs and increases in the costs of component parts of raw materials.
External causes of inflation:
These are inflationary pressures from outside of a particular country-for example arising from an increase in the global price/cost of energy and other inputs.
Movements in the exchange rate of a country’s currenc can also affect inflation.(For example if the currency weakens then it will cause imported goods to become more expensive,pushing up domestic costs).
Why can inflation be difficult to remove once it becomes established?
Inflation can be difficult to remove because agents (workers, businesses, lenders) raise their inflation expectations and factor it into their decisions, leading to a cycle of higher prices and wages.
How does a rise in inflation affect inflation expectations?
A rise in inflation can increase inflation expectations, leading to higher wage claims and rising costs as businesses adjust their prices and workers demand higher wages.
What is cost-push inflation?
Cost-push inflation occurs when the costs of production for businesses increase, such as higher wages, raw materials, rents, or taxes. This can reduce output and employment and may lead to stagflation.
What is stagflation?
Stagflation is a combination of slow economic growth and rising inflation, often resulting from cost-push inflation. A notable example is the 1970s oil price shock.
What is demand-pull inflation?
Demand-pull inflation happens when total demand for goods and services exceeds supply, often as the economy reaches full employment. This drives prices up as producers raise their prices to maintain profit margins.
How is demand-pull inflation related to economic growth?
Demand-pull inflation is typically associated with rising real GDP and increased employment as economic demand grows.
How does the growth of the money supply relate to inflation?
If the money supply grows faster than the economy, inflation tends to occur, often referred to as "too much money chasing too few goods," which can be explained by the quantity theory of money (MV = PT).
What is the Fisher Formula (MV = PT)?
The Fisher Formula (MV = PT) shows the relationship between money supply (M), velocity of money (V), price level (P), and total output (T). When M increases and V and T remain constant, P (prices) will rise.
What are the winners from rising inflation?
Winners include:
Workers with strong wage bargaining power
Debtors with negative real interest rates
Producers whose prices rise faster than costs
Wealthy individuals during periods of asset price inflation
What are the losers from rising inflation?
Losers include:
Retired people on fixed incomes
Lenders if real interest rates are negative
Savers if real returns are negative
Low-paid workers with little bargaining power
Exporting firms losing competitiveness
Why do most governments target a low, positive inflation rate?
Governments target a low, positive inflation rate (e.g., 2%) because moderate inflation is associated with economic growth and rising employment, and 0% inflation could stifle economic activity.
What is the target inflation rate in the UK?
The target inflation rate in the UK is 2%, as measured by the consumer price index.
What are some risks of high and volatile inflation?
Risks include:
Inequality
Falling real incomes
Negative real interest rates
Higher cost of borrowing
Risks of wage inflation
Reduced business competitiveness
Business uncertainty
How does inflation affect inequality?
Inflation has a regressive effect on lower-income families because most of their wealth is held in cash, which loses value as prices rise.
How does inflation affect real incomes?
If wage increases lag behind price increases, real incomes fall, reducing the purchasing power of workers.
What happens when real interest rates are negative due to inflation?
Negative real interest rates (when inflation is higher than interest on savings) erode the real value of savings and reduce savers' incomes.
How does high inflation affect the cost of borrowing?
High inflation can lead to higher interest rates on loans, including mortgages, increasing the cost of borrowing for both businesses and consume
What is wage inflation?
Wage inflation occurs when wages increase faster than productivity, leading to rising labor costs and potentially lower business profits.
How can high inflation affect business competitiveness?
A high rate of inflation can reduce a country's competitiveness by making its exports more expensive, lowering demand for goods in foreign markets.
What effect does high inflation have on business uncertainty?
High and volatile inflation creates uncertainty about costs and prices, which may reduce business confidence and lead to a decline in capital investment.
What factors influence the effects of high inflation?
Factors include:
Whether inflation is temporary or persistent
Inflation rates in major trading partner countries
Central bank responses to inflation
Wage bargaining power of workers
Whether interest rates on savings and loans keep pace with inflation
The impact of uncertainty on investment
What are the causes of deflation?
Causes include:
Demand-side causes (malign deflation) — a deep fall in total demand, often leading to recession and high spare capacity.
Supply-side causes (benign deflation) — an increase in total supply due to factors like improved productivity or technological advances.
How does an exchange rate affect deflation?
A strong exchange rate can cause import prices to fall, which can shift short-run aggregate supply (AS) outward, contributing to deflation.
Economic effects of deflation
Holding back on spending: consumers may postpone demand if they expect prices to fall further in the future.
This lowers aggregate demand and can cause a deeper fall in real GDP i.e. prolonged recession
Debts increase: the real value of debt rises when there is price deflation and higher real debts can be a big drag on consumer confidence and spending
The real cost of borrowing increases: real interest rates will rise if nominal rates of interest do not fall in line with prices
Lower profit margins: lower prices reduce revenues and profits for businesses - this can lead to higher unemployment as firms reduce costs by shedding labour
Confidence and saving: falling asset prices such as price deflation in the housing market hits personal sector wealth and confidence
Income distribution: deflation leads to a redistribution of income from debtors to creditors but debtors may then default on loans
Deflation can make exporters more competitive eventually but this often comes at a cost i.e. a higher rate of unemployment in the short
