Inflation

What is inflation?

A sustained rise in the general price level

What is disinflation?

A fall in the rate of inflation

What is deflation?

A decline in the general price level (inflation rate below 0%)

What is the inflation rate?

The annual rate of change of the average price of goods and services

What is the official measure of the inflation rate in the Uk?

Consumer Price Index (CPI)

What is CPI based on?

The average price of a bundle of 720 goods and services measured at different times from a sample of 7000 households

What does each household do?

A price and expenditure survey

What makes CPI more accurate?

Weighting of the goods based on typical spending patterns

What two things does CPI exclude?

• Housing costs (mortgages)

• Council tax

What makes CPI more representative of consumer habits?

Goods are reviewed and updated each year

What is an index number?

A figure reflecting price or quantity compared with a base value?

What always has an index number of 100?

The base value

How is an index number calculated?

Index number in Year Y = (Data value in Year Y / Base Year Value) x 100

What is the Bank of England’s target inflation rate?

2%

What is Hyperinflation?

When money loses its value so rapidly that it loses its use as a medium of exchange (Inflation is grater than 100%)

How does hyperinflation occur?

• Inflation means people need more money to buy the same good

• Demand for cash rises so gov prints more money

• Wage–price spiral develops

• More and more inflation

What are the effects of hyperinflation?

• Collapse in business and consumer confidence

• Savings become worthless - recession

• New monetary system created

What are 3 main differences between CPI and RPI?

• RPI includes mortgage interest payments and other housing costs

• CPI excludes council tax

• Changes in interest rates heavily effect RPI but not CPI

What is each measure more useful for?

• CPI - excludes volatile house prices so can be compared with other countries more easily

• RPI - includes house prices so more useful for UK where house ownership is high

What percentage of UK households were owner - occupiers in 2021?

62.5%

What are the two main limitations of the CPI?

• Doesnt take into account top and bottom 4% of income earners

• Worse for Uk (home - owners)

What are the 4 internal causes of inflation?

• Large increase in house prices

• Higher wage / lavour costs

• Boom in credit (money supply)

• Rise in business taxes

What are 4 external causes of inflation?

• Increase in world oil prices

• Rise in global commodity prices

• Depreciation of exchange rate

• High inflation in other countries

What are the two types of inflation and what do they mean on a diagram?

• Demand - pull (Outward shift in AD)

• Cost - push (Inward shift in SRAS)

What is demand pull inflation?

Where an increase in demand (rise in AD) causes scarcity and hence firms raise prices to keep / increase profits

What are 5 causes of demand pull inflation? (components of AD)

• Depreciation of exchange rate

• Reduction in direct taxation

• Growth of money supply (bank credit)

• Rising consumer confidence (wealth effect)

• Strong growth in trading partners

How does a depreciation of the exchange rate cause demand - pull?

Increased price of imports

How does strong growth in trading partners cause demand pull?

More demand for UK exports (X rises so AD rises)

How is demand pull shown on a graph?

• Outward shift in AD

• Expansion in SRAS

• Growth increases

What is cost - push inflation?

Where an increase in costs is passed onto consumers forcing prices up to maintain profits

What are three main causes of cost push inflation (SRAS - cost of production)?

• External shocks - affecting commodity prices

• Depreciation of exchange rate

• Higher wage demands

How perpetuates cost push inflation?

Wage - price spiral

What is stagflation?

When there is rising inflation and lower growth

Why is cost push inflation more difficult to control?

• It deals with problems of supply (more structural)

• Cant raise interest rates to reduce consumer spending as it would impact growth badly

What are 3 long term ways to tack supply issues and prvent cost push inflation?

• More flexible labour markets

• Stock piling oil reserves

• Policies to increase competitiveness

What are 3 negative impacts of high inflation on consumers?

• Inequality - low income families have fixed incomes and work cash in hand

• Falling real incomes - wages lag behind prices

• Negative real interest rates - peoples savings lose value

What are 3 negative impacts of high inflation on businesses?

• Fall in business competitiveness - higher CoP so less competitive causing long unemployment

• Business uncertainty - unsure about costs and prices potentially lowering capital investment

• Wage inflation - higher wage demands to keep standard of living

Who are the winners from high inflation?

• Workers with strong wage bargaining power

• Producers if prices rise faster than costs

Who are the losers from high inflation?

• Lenders if real interest rates are negative

• Workers in low paid jobs (bargaining power)

• People who are retired and are on fixed incomes

How does expectation of inflation lead to inflation?

• Consumers buy now to avoid higher prices (AD rises)

• Firms raise prices to expect wage demands

What determines the expected rate of inflation?

Monetary policy and confidence in authorities

What should policies do to control inflation?

• Slow down growth of AD

• Boost SRAS

How could fiscal policy be used to control inflation?

• Austerity - less spending on public/merit goods

• Contractionary - raise direct taxes to reduce C

How could monetary policy be used to control inflation?

• Higher interest rates - exchange rate appreciates - imports become cheaper

• More control on bank lending - reduce money supply

What type of policies increase productivity and competition?

Supply - side policies

What are 2 direct controls the gov could use?

• Public sector pay controls (limiting pay rises NHS)

• Regulation of price utilities (lower cost of production)