2.4 Inflation

Consumer price index (CPI)

A measure of the price level in the economy based on the prices of a collection of products designed to reflect the consumption basket of the average consumer

Deflation

A decline in the general price level in an economy signified by an annual inflation rate below 0% negative

Disinflation

A fall in the rate of inflation. Prices are still rising but at a slower rate.

Hyper-inflation

A period of very high rates of inflation (30%+) usually leading to a loss of confidence in an economy’s currency

Inflation rate

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

Unit labour costs

Reflects total labour costs, including social security and employers’ pension contributions, and including the costs of self-employed labour, incurred in the production of a unit of economic output

Retail prices index (RPI)

Measures the average level of prices relative to a previous base year

Demand pull inflation

Caused by an increase in AD

Cost push inflation

Caused by rising costs of inputs to production

Inflation target

2% (with 1 or -1 % leeway)

Monetary policy committee (MPC)

Sets monetary policy interest rates so that inflationary pressures are controlled and the inflation target is reached

Limitations of the CPI as a measure of inflation

Not fully representative as it will be inaccurate for the non-typical household

Spending patterns differ between households; single people will definitely spend differently than people with children

It doesn’t consider the changing quality of goods and services; although prices may rise, this is often accompanied by improvements in quality or performance

It is slow to respond to new products; despite being changed every year, only a few items get added or removed

RPI vs CPI

The retail price index is used for adjusting pensions and other benefits. It includes housing costs like mortgages and council tax, which makes its value higher than the CPI.

Same principles as the CPI but uses a different basket of goods/services to measure inflation and the average is calculated in a different way

Causes of demand pull inflation

Excess aggregate demand

Credit boom

Economy close to full capacity (inelastic AS)

Causes of cost push inflation

Rising wage costs

Increasing raw material and component costs from domestic and overseas suppliers

Rising import costs due to a falling exchange rate

Deflation curve

Demand side causes of deflation

Big fall in AD causing a persistent recession/depression

Large negative output gap - high level of spare capacity

Supply side causes of deflation

Improved productivity

Technological advances

Significant fall in wage rates

High exchange rate causing import prices to fall

Economic consequences of high inflation

Inequality: affects low income families the most

Falling real income: if wage rises lag behind price increases each year

Negative real interest rates: If the interest on savings is lower than inflation

Cost of borrowing: High inflation may also lead to higher interest rates for businesses and consumers with debts

Risks of wage inflation: This leads to rising labour costs and lower profits

Business competitiveness: A high relative rate of inflation can reduce competitiveness which will lower demand for a country’s exports

Business uncertainty: High and volatile inflation is not good for confidence as businesses cannot be sure what their costs or prices are likely to be so there will be a fall in capital investment

Consequences of deflation

Holding back on spending: Consumers may postpone demand if they expect prices to fall in the future

Debts increase: The real value of debt rises with deflation and higher real debts can be a drag on consumer confidence

The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices.

Lower profit margins: Lower prices can mean reduced revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.

Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence

Income distribution: Deflation leads to a redistribution of income from debtors to creditors

Policies to control inflation

Fiscal policy: A tightening fiscal policy would include less spending on public and merit goods or welfare payments or raising direct taxes

Monetary policy: A ‘tightening of monetary policy’ via higher interest rates or a reversal of quantitative easing or tougher controls on bank lending

Higher interest rates may cause the exchange rate to appreciate

Bringing cheaper imported goods and services

Supply side policies to increase productivity, competition and innovation

Direct controls: Public sector pay controls e.g. Limiting pay rises for NHS workers, Capping or other regulation of prices of utilities such as water bills