Price Stability

what is inflation?

A sustained increase in the general price level of goods over a period of time, causing a fall in the purchasing power of money.

what is inflation typically measured in?

The Consumer Price Index (CPI)

Why is inflation important to measure?

because it is essentially an indicator of the cost of living.

what inflation rate does the government aim for?

2%, with a leeway of ± 1%

what are 2 reasons why the govt. wants inflation to be 2%?

• Encourages economic activity- if consumers know price will increase within a year, encourages them to buy now.

• Firms generate more revenue- more profit from firms charging higher prices means they are more likely to invest and grow- multiplier effect.

define demand pull inflation

Increases in the price level caused by increases in Agg. Demand- AD increases at a faster rate than AS.

why does an increase in AD cause demand pull inflation?

Because there is an greater pressure on the existing factors of production to produce more output- usually occurs near or at a country’s productive capacity.

price of FoP increases→ firms costs increase → new costs are passed onto consumer as an increase in price.

what is the classical graph for demand pull inflation?

AD shifts from AD1 to AD2, SRAS stays the same, causing an increase in price level.

what are the six main causes of demand pull inflation?

• rising domestic employment and incomes

• rising incomes abroad

• depreciation of exchange rates- UK exports appear cheaper

• loose fiscal policy- low income tax/ govt. spending

• loose monetary policy- low interest rates

• large multiplier (due to high MPC & low MPW)

what is the keynesian model for demand pull inflation?

AD1 shift to AD2, increasing GDP but also rising Price level.

What are the 5 key solutions for demand pull inflation?

Solved by reducing AD:

• increasing income tax- fall in net incomes

• increasing interest rates- reward to saving increases & higher cost of borrowing

• increasing interest rates- appreciates value of currency & makes UK exports appear more expensive

Also Solved by increasing Firms’ Ability to Supply

• cutting regulations

• increasing/ improving infrastructure to enable more raw materials to be transported and goods produced.

what is cost push inflation?

This is caused when firms see a rise in their costs, so increase their prices to protect profits.

To impact general prices, the costs rising must affect many firms and goods (in the basket of goods)

what is the classical model for cost push inflation?

SRAS decreases from SRAS1 to SRAS2, causing an increase in price level.

what is the keynesian model for cost push inflation?

• The AS curve shifts left/up (to a steeper part), meaning it now costs more to produce the same amount.

• As a result, prices go up (from PL1 to PL2) even though output may fall (from Y1 to Y2).

• This leads to higher prices and lower GDP, which is bad for the economy.

what are the causes of cost-push inflation?

• increase in the prices of raw materials and components

• depreciation of currency

• increase in indirect tax (VAT)

• increase in labour costs

  • wage increase that exceeds productivity growth so increase in costs per unit

  • Increase in National Minimum wage

    • Trade union negotiations

what are the solutions for cost push inflation?

• Raise interest rates to appreciate the value of the currency which will make imported raw materials cheaper

• Cut VAT rate

• Only raise NMW when conditions allow firms to pay workers more but not need to raise prices

what are the 4 consequences of inflation for consumers?

• Real incomes fall

  • those on fixed incomes see a decrease in real income- can buy fewer G&S with their income → fall in standard of living

• Consumers as Debtors

  • debt is at a fixed cost, does not change w/ inflation. If income rises w/ inflation, debtors will find it easier to pay off debt

• Consumers as Savers

  • Suffer as money in the bank loses value, e.g. £1000 buys fewer goods next year. BoE may increase interest rates to lessen negative impact

• Shoeleather costs- real incomes fall so shoppers travel to look for the lowest price to maintain purchasing power- costs incurred from travelling around.

What are the three consequences of inflation for firms

• Menu Costs

  • when increasing price, firms need to communicate this to customers. New menus, adverts, packaging etc. creates extra costs.

• Labour Mkt. Conflicts

  • when real incomes fall, trade unions bargain for higher wages to maintain standard of living. Workers may strike → loss of output and revenue

• Producers Lose as Creditors

  • firms may have a buy now pay later scheme. Money received at a later date is less than the initial time of payment

what are the four consequences of inflation for governments?

• Wage costs

  • trade unions representing public sector workers will bargain for higher wages-