2.1.2 - Inflation

What is inflation?

The sustained increase in the average price level of goods and services in an economy over a period of time

What is deflation?

The sustained decrease in the average price level of goods and services in an economy over a period of time

What is disinflation?

When the inflation rate decreases but REMAINS positive

What is the CPI?

The consumer price index measures the price of a set basket of consumer goods between one time period and another

How do you work out the CPI when given prices and weights?

Work out the total of prices before (price times by weight (As a decimal) and then sum). Do the same for the prices now. Work out the difference and divide the difference by the old price. Times by a hundred to get a percentage and then add this number to a hundred to get the index

What is the first step of the actual process of the CPI?

A household spending survey is conducted to ascertain what households spend their income on.

Second step?

Items are split into spending categories and how much households spend as a proportion of their total income is recorded. This allows a weighted basket of over 500 gods to be created - goods with a higher proportion of spending are represented by a higher weighting

Third step?

A price survey is then conducted each month, collecting 180,00 prices of these goods from different parts of the country and different stores

Fourth step?

An average price for each good is then calculated which is then converted into an index, compared to a baselines price for each item, to show how much their prices has changed over the year

Final step?

This is then multiplies by the weighting of the good in the basket to create the overall price index, which then can be reviewed to calculate inflation rates

What is the RPI as an alternative of the CPI?

The retail price index measures the change in cost of a basket of goods and services, including housing costs such as mortgage interest payments, council tax and housing depreciation

What are the problems and limitations of measuring inflation?

Most household’s individual basket of good will not match the CPI’s

Households with very different income levels are compared

Basket of goods change over time, making it difficult to compare

Each countries basket of goods is different, making it difficult to compare

What is demand pull inflation?

Occurs when overall demand for goods and services in an economy increases faster than the economy’s ability to produce them. When demand “pulls” ahead, firms respond by raising prices

Shown on a graph by an outward shift of AD causes by consumers, firms or the government spending more

What are the common causes?

Rising household’s incomes

Increase in government spending

Low interest rates

economic BOOM

What is cost push inflation?

Occurs when the costs of production increase, causing firms to raise prices in order to maintain profit margins. Prices rise even if demand has not increased

Shown on a graph by an inward shift of SRAS

What are the common causes?

Rising TWICE

What is the wage price spiral?

An increase in AD leads to demand pull inflation. Real income would fall if wage increases fail to keep peace with inflation. Therefore workers strike to protect real pay, and negotiate better wages. Costs of production for firms increase and therefore firms raise their prices to protect their profits which leads to inflation and therefore a wage price spiral

What are the negative impacts of inflation?

Uncertainty about future levels of wealth profit can not be predicted so firms may reduce overall investment

Costs of producing new menus, catalogs etc. Cost of production increases for firms

Inflation leads to people mistakenly thinking they are wealthier than they are, leading to incorrect spending decisions

Shoe leather costs - time and effort shopping around for a good deal increases as inflation leads to uncertainty about the best/true price of the good

What is a cause of deflation?

A deep fall in AD causing a persistent recession - a large negative output gap arises as a consequence due to spare capacity

What is another cause of deflation?

An increase in supply leading to an outward shift of SRAS - can be caused by improved productivity, technological advancements and TWICE decreasing