Inflation 2.1.2

What is inflation?

A sustained rise in an economy’s general price level.

What is the consumer price index?

It is a measure that tracks changes in the average price level of a basket of goods and services purchased by a typical household over time.

It is a weighted price index.

What are weights based on?

The spending pattern of households.

How do you calculate inflation using a price index?

• Selection of the basket of goods and services

• Determination of the weights based on spending patterns

• Price data collection including recall and online prices

• Calculation of price index using weights.

What are limitations of the Uk consumer price index?

• The CPI basket is not representative of all consumers.

• Errors/ inaccuracy in data- i.e. sampling errors in survey’s.

• Many of the services in the digital economy do not have a price such as Google services.

• Changing quality of goods and services: a rise in the quality of products may not be reflected in prices we pay.

• Time-lags- slow to respond to new products in markets- the CPI basket is change each year but only by a little.

What are challenges in measuring inflation?

• Basket of goods and services- consumer preference changes over time.

• Substitution bias- consumers change spending patters in response to price changes.

• Quality adjustments- the CPI must make quality adjustments to account for quality changes, which can be subjective.

• Geographic variation- national measure and may not capture regional variations in prices efficiency.

• Subgroups and demographics- CPI represents an average consumer, but inflation experience may vary among groups.

What is hyper-inflation?

A phase of extremely rapid inflation nearly always the result of mass money printing by the government with money as an asset ending up as worthless.

What is hyper-inflation associated with?

Economies where there has been a collapse in real output/supply.

What is deflation?

A sustained period when the general price level for goods and services is falling.

What is the effect of deflation on a basket of good and services?

The weighted basket of goods and services becomes less expensive over time.

What is disinflation?

A fall in the rate of inflation but not sufficient enough to bring about price deflation.

What happens during a period of disinflation to the prices?

Consumer prices are still rising but at a slower rate.

What are inflation expectations?

What people and businesses expect to happen to consumer prices in the future.

What is the wage price spiral?

Once a high rate of inflation becomes established it can be hard to remove. If people expect higher prices, this can then feed through to higher wage claims and rising costs.

What is stagflation?

Refers to an unfortunate and costly combination of stagnant (slow) economic growth, rising unemployment and high and rising inflation.

What are the main causes of inflation?

• Money and credit boom

• Higher wage costs

• Increased energy bills

• Falling exchange rates

• Economic boom

When does Cost-Push Inflation occur? 

Occurs when businesses respond to rising unit costs by increasing prices to protect their profit margins

What are some causes of Cost-Push Inflation?

• Rising labour costs (perhaps due to increase in minimum wage)

• Higher global prices for components and raw materials including imported energy and foodstuffs

• A depreciation in the external value of the exchange rate which causes a rise in import prices

• An increase in indirect taxes such as higher VAT or environmental taxes

Why is inflation from Cost-Push inflation factors difficult to control?

Since the central bank has little control over the factors that cause it

What is Demand-Pull Inflation?

A phase of accelerating inflation which arises from a rapid growth in aggregate demand

When does Demand-Pull Inflation occur?

Occurs when economic growth is too fats. Businesses can take advantage if high demand by raising their prices to widen (increase) profit margins

What economic event is demand pull inflation typically associated with?

An economic boom

What are some of the causes of Demand-Pull Inflation?

• Economic growth

• Low interest rates

• An increase in the money supply

• If the government engages in excessive fiscal stimulus, like cutting taxes

• Increase in government spending

• Real wage increase

What were the three causes of the surge in UK inflation in 2022-23?

• Pandemic-related supply shortages

• Conflict in Ukraine

• Labour shortages

How did pandemic related supply shortages cause the surge in UK inflation in 2022-23?

After the pandemic demand increased but supply couldn’t keep up which led to higher prices for raw materials and products, this pushed up inflation.

How did conflict in Ukraine cause the surge in UK inflation in 2022-23?

It caused a spike in energy prices, as Russia is a major exporter of natural gas and other fuels. Higher energy prices have pushed up the cost of production for many businesses.

How did labour shortages cause the surge in UK inflation in 2022-23?

Labour shortages have been a big problem in the UK, especially in sectors like healthcare and logistics. A lack of workers has made it difficult for businesses to operate and it’s pushed up wages for those workers who are available.

What is greedflation also known as?

Price gouging

What is price gouging?

Refers to the practice of charging excessive or unreasonable prices for goods or services in response to a situation of increased demand or supply, such as during a natural disaster, pandemic or other emergency.

What is shrinkflation?

Refers to the practice of companies reducing the size or quantity of a product, while keeping the price the same or even raising it.

What does shrinkflation allow companies to do?

Allows them to keep prices stable or even increase them without consumers noticing much.

What form of inflation is shrinkflation?

A form of ‘‘hidden inflation’’ that can be difficult to detect.

What are the economic costs of high inflation?

• Inequality: inflation has a regressive effect on lower-income families

• Falling real income

• Negative real interest rates: if the interest rate on savings is lower than inflation

• Cost of borrowing: high inflation can lead to higher interest rates

• Business uncertainty: High and volatile inflation is not good for confidence

Why might investors worry about the stability of an economy when there is high inflation?

They fear the high inflation will lead to a decline in the value of the countries currency

What is ‘capital flight’?

When investors decide to mover their money out of a country to protects their assets

What is a wage price spiral?

A situation where workers bid for higher wages because they have seen their real income eroded by fast-rising prices.

Why does a countries relative inflation rate matter?

A countries relative inflation rate can affect its competitiveness in international trade.

What does a country with a high inflation rate experience in comparison with one with low inflation?

The country with high inflation will see its exports decline

What does a country with a low inflation rate experience in comparison with one with high inflation?

The country with low inflation will see its exports increase.

What happens to a countries competitiveness when it has high inflation?

It becomes less competitive in the global marketplace- less Foreign Direct Investment (FDI)

Who are the potential winners from high inflation?

• Suppliers of inferior goods

• Workers with strong wage bargaining power

• Debtors if real interest rates on loans become negative

• Producers if their prices continue to rise faster than costs.

Who are the potential losers from high inflation?

• Retired people relying on fixed pensions/ income

• lenders if real interest rates on loans are negative

• Savers if real returns on their savings deposits are negative

• Workers in low paid jobs with little or no bargaining power

What are the possible costs of inflation for a government?

• Pressure to raise the value of state welfare benefits

• Real GDP growth slowdown- lower tax revenues and government have to borrow more money

• Increased market interest rates making government borrowing more expensive when they issue new bonds

• Worsening of international competitiveness causing a fall in exports which can threaten jobs and GDP growth

What are potential benefits of inflation for a government?

• Fiscal drag- this happens when people’s wages/ incomes are rising in nominal terms which causes them to pay more in direct and indirect taxation

• Reduction in the real value of the government’s existing/ outstanding debt

• Real interest rate on borrowing money might be negative if the nominal yield (on a gov bond) is less than the rate of inflation

• Moderate positive inflation helps businesses to make higher profits which generates more tax revenue