2.1.2 Inflation

What is inflation?

The sustained increase in the average price level of goods/services in an economy

how do we check average price levels

by checking the prices of a basket of goods/services that an avg household will purchase each month

what is the CPI

Consumer price index- a way to measure the average price level by checking the prices of the basket of goods/services purchased by the avg household monthly

What is the UKs inflation target

A CPI at 2% per annum

What is deflation?

a fall in the average price levels of goods/servoces in an economy- percentage change falls below 0

What is disinflation?

when the average price level is still rising, but at a lower rate than before

How is inflation rate calculated

through percentage change between one year to the next

What inflation indices does the uk use?

Consumer Price Index CPI + Retail Price Index RPI

How do we decide what enters the basket of 700 goods/services

Through a household expenditure survey → some exit, some enter every year

How do we measure CPI?

• prices from chose goods/services are gathered from 150 locations across the UK and are averaged out for each product

• Price * weighting determines final value of goods/service → final values are added up to get total vale of basket

• CPI= (cost of basket in year X / cost of basket in base year )*100

• Percentage difference between the years shows inflation rate for the period

What are the limitations of CPI?

• ignores regional differences in inflation as an average

• Does not capture quality of products in the basket

• Only measures changes in consumption on an annual basis but inflation rate changes frequently(monthly)

• Prone to errors in data collection given their is no insentive to be accurate on the household expenditure survey + based on a small sample

What is RPI?

CPI but includes council tax, mortgage interest payments. House deprecation +other household purchasing costs

How nd why does RPI differ from CPI?

Due to the extra inclusions, inflation rate measured through RPI tends to be more than CPI due to sensitivity to interest rate changes (affects mortgage interest) → arguably more accurate

What are the causes for inflation?

• Demand-pull inflation

• Cost-push inflation

• Growth of money supply + wages

What is demand pull inflation caused by?

An excess in demand in the colony

What is aggregate demand?

the sum of all expenditure in the country

AD= Consumption (C) + Investment (I) + Gov spending (G) +Net exports (X-M)

AD= CIGN

What is short run aggregate supply (SRAS)

the total supply provided in the con at a given average price level

What is cost-push inflation caused by?

increases in cost of production in an economy

How does changes to money supply affect inflation?

If the Central Banks lowers its base rate (the rate of interest on money it lends) → increased borrowing →increase in consumption + investment → leads to demand pull inflation

How does changes in wages affect inflation?

Increase aggregate demand → demand- pull inflation → workers feel less well off due to decreased purchasing power → demand wage increase to offset that → wage increase leads to cost-push inflation → prices get even higher. This phenomenon is called the wage-price spiral

What is the effect of inflation on firms?

uncerainty due to rapid price changes

Menu price changes = expensive

What are the effects of inflation on consumers?

• decrease in purchasing power

• Decrease in the real value of savings

• Fall in real income

What are the effects of inflation on the government?

• erodes international competitiveness of export industries

• Difficult to tackle inflation without high opportunity cost i.e can cause unemployment or reduce economic growth

What are the effects of inflation on workers?

• demand of higher wages due to reduced purchasing power

• Can cause a a fall in motivation or productivity