2.1.2

What is inflation?

A sustained rise in the general price level over time; erodes the purchasing power of money

What is deflation?

A sustained fall in the general price level; can signal falling output, rising unemployment and can delay consumer spending as people wait for lower prices

What is disinflation?

A fall in the rate of inflation — prices are still rising, but more slowly than before

How is the CPI calculated?

A weighted basket of around 710 goods and services is selected based on average household spending (from the Living Costs and Food Survey); prices are collected from 20,000 outlets and weighted by importance to give a single index

What are the limitations of CPI as a measure of inflation?

It excludes housing costs (mortgages, council tax); uses an average basket that may not reflect individual spending patterns; slow to include new goods; doesn't capture quality improvements; ignores spending differences between rich and poor households

What is the RPI and how does it differ from CPI?

The Retail Prices Index also measures inflation but includes housing costs (mortgage interest payments, council tax); it excludes the top 4% of earners and low-income pensioners; RPI is generally higher than CPI and uses a different averaging method (arithmetic vs geometric mean)

What causes demand-pull inflation?

Excess demand in the economy — too much money chasing too few goods; associated with strong economic growth, rising consumer confidence or loose monetary/fiscal policy; shown as AD shifting right

What causes cost-push inflation?

Rising production costs (e.g. wages, raw materials, energy prices) reduce firms' ability to supply at existing prices; AS shifts left, pushing up the price level even without excess demand

What causes inflation through money supply growth?

The monetarist view: if the money supply grows faster than real output, there is more money chasing the same goods, pushing prices up; associated with excessive money printing or credit creation

What are the effects of inflation on consumers?

Real incomes fall if wage rises don't keep pace with inflation; debtors benefit as the real value of debt falls; savers lose as the real value of savings is eroded; uncertainty may reduce spending and confidence

What are the effects of inflation on firms?

Menu costs (cost of updating prices); loss of international competitiveness if UK inflation is higher than trading partners'; uncertainty makes long-term investment planning harder; input costs rise squeezing profit margins

What are the effects of inflation on workers?

Real wages fall if pay rises lag behind inflation, reducing living standards; workers may demand higher nominal wages, risking a wage-price spiral; industrial disputes more likely

What are the effects of inflation on the government?

Fiscal drag: rising nominal incomes push taxpayers into higher brackets even if real income is unchanged; debt easier to service in real terms; but higher indexation costs for benefits and pensions; credibility of monetary policy may be damaged