2.1.2: Inflation

What is inflation?

• The sustained rise in GDP over time

• The target rate in the UK is 2%

What is deflation?

• When the average price level falls and there is a negative inflation rate

What is disinflation?

• The falling rate in inflation

• Happens when the average price level is rising but at a slower rate

• Goods and services are relatively cheaper as a result due to the PP of money increasing

What is CPI?

• Consumer price index

• One method of calculating inflation

• Measures household PP with the family expenditure survey

• Survey finds out what consumers spend their income

• A basket of goods is created from this and these goods are weighed proportionately to the income spent on them

• Updates anually

Limitations of CPI

• The basket of goods is only representative of the average household- not accurate for households who don’t own cars etc

• Different demographics have different spending habits/ patterns so not fully representative of the true population

• CPI is slow to respond to new goods and services

• It is difficult to make historical comparisons due to the differences in technology

What is RPI?

• Retail price index

• Another measure of inflation

• Unlike CPI, includes housing costs such as mortgage interest and council tax

• Tends to have a higher value than CPI

• Excludes the top 4% of earners and low income pensioners- generates a more true/ accurate representation

• However, RPI doesn’t take into account that when prices rise people will switch to products that have gone up by less unlike CPI

Causes of inflation: Demand pull

• Is when AD grows unsustainably which puts pressure onto the supply of resources

• As a result, producers increase pressure and profits

• Usually occurs when resources are fully employed

• A depreciation in exchange rate can be a trigger for this due to the fact that imports become more expensive, and exports become cheaper- causing AD to rise

Causes of inflation: Fiscal stimulus

• Lower taxes or an increase in Government spending results in more disposable income for consumers

• This would result in an increase in consumption due to consumers being able to have an increase in MPC

• If there was a decrease in interest rates, this would decentivise saving and therefore encourages spending

• This could result in higher exports and therefore higher AD due to AD= C+G+I+X-M

Causes of inflation: Cost push

• Occurs when there is an increase in the price of raw materials or increase in the costs of labour e.g: via trade union

• Is caused from the supply side of the economy and occurs when firms increase costs

Causes of inflations: Expectations of inflation

• If consumers expect an increase in prices, they may ask for higher wages which in turn could result in increased consumption and therefore wage inflation via self fulfilling prophecy

Causes of inflation: Indirect taxes

• Occurs when increased costs/ taxes are placed on goods like cigarettes or alcohol

• As a result consumers pay more as the consumers pass this cost onto the consumer- by paying more they are indirectly contributing to inflation

Causes of inflation: Growth of the money supply

• If the Bank of England printed more money, there would be an increased supply into the economy

• This as a result reduces the PP of money and can even result in hyperinflation in drastic scenarious

• However, this will only have an inflationary effect if the money supply increases at a faster than the real output

Depreciation in the exchange rate

• When the costs of imports increase, the price of raw materials are also pushed up

Monopolies

• They are able to use their dominant market power to exploit consumers with high prices

• These high prices further contribute to inflation

The impacts of inflation: Consumers

• Those on low and fixed incomes are hit the hardest as it has a regressive effect by increasing the cost of necessities and reducing the PP of money

• However, it also reduces the real value of loans and interest payments due to not adjusting with inflation

The impacts of inflation: Firms

• Lower interest rates mean that borrowing and investing becomes more attractive than saving profits

• However, if inflation is high, firms will be less likely to invest due to the cost being higher

• Workers may also demand higher wages to cope with inflation which would increase the costs for firms

• Firms may also be less price competitive internationally due to to an increase in exports and potentially even raw materials (dependant on how it was caused)

• Unpredictable inflation will reduce business confidence and therefore reduce FDI which reduces injections in to firms

The impacts of inflation: The Government

• Increases costs due to the value of welfare payments having to increase to adjust to the increased cost of living

• Reduces the real value of debt

The impacts of inflation: Workers

• Real incomes fall with inflation which therefore reduces their MPS and increases their MPC

• Decrease their PP

• They could also be made redundant by firms as an attempt to reduce costs

• However, skilled workers with high bargaining power or workers with the help of a union could negotiate higher wages